NutriSystem Inc. Q4 2007 Earnings Call Transcript

NutriSystem Inc. (NTRI)

Q4 2007 Earnings Call

February 19, 2008 5:00 pm ET

Executives

David Clark - CFO

Mike Hagan - Chairman and CEO

Joe Redling - President and COO

Analysts

Greg Badishkanian - Citigroup

Colin Sebastian - Lazard Capital Markets

Vivian Ma - Oppenheimer & Co.

Laura Richardson - BB&T Capital Markets

Bill Sutherland - Boenning & Scattergood

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the quarter-four 2007 NutriSystem Earnings Call. My name is Nikita and I will be your coordinator for today. (Operator Instructions)

I would now like to turn the presentation over to your host for today's call, Mr. David Clark, Chief Financial Officer. Please proceed, sir.

David Clark

Thank you, operator. Good afternoon, everyone, and thank you for joining us to discuss NutriSystem's full year and fourth quarter 2007 financial results. With me today from management are Mike Hagan, Chairman and Chief Executive Officer; Joe Redling, President and Chief Operating Officer; Tom Connerty, Chief Marketing Officer and Executive Vice President; and as stated earlier, I'm David Clark, Chief Financial Officer.

I would like to remind everyone that this announcement contains forward-looking statements that involve risks and uncertainties. Such information includes statements about NutriSystem's fourth quarter financial results, as well as statements that are preceded by, followed by or include the words believes, plans, intends, expects, anticipates or similar expressions.

Statements regarding NutriSystem's outlook and guidance for the first quarter of 2008 and the full year 2008 and its expectations on the effect of the economy on consumer spending and other similar statements are not statements of historical facts and constitute forward-looking statements. For such statements, NutriSystem claims the 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 reported results should not be considered as an indication of future performance. Factors that could cause actual results to differ from those contained in 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, 2006, which has been filed with the SEC. NutriSystem is making these statements as of February 19, 2008, and assumes no obligation to publicly update or revise any of the forward-looking information in this announcement.

I would also like to point out that we have a couple of PowerPoint slides available through the call that are webcast on our Investor Relations website that illustrate some points on reactivation and customer economics that we will discuss in a few minutes.

With that, I would like to turn the call over to Mike Hagan, Chairman and CEO.

Mike Hagan

Thanks, David. Good afternoon and thank you for joining us on today's conference call. First, I'd like to summarize our fourth quarter and full year 2007 results. Next, David Clark will take you through a detailed view of our financials for the quarter. Joe Redling will then provide you with a look in to our marketing and product development initiatives with a closer focus on what we have been seeing early on in 2008. At the conclusion of Joe's remarks, we'll open it up for questions. Tom Connerty, our Chief Marketing Officer, is also here with us for Q&A.

Now let me review some of the fourth quarter results which pretty much either hit or slightly exceeded the guidance that we provided you back in October. Revenues came in at a $137 million and that's up 3% year-over-year. First time customers came in at a $131,000, down about 18% from the prior year and operating income came in at roughly $15.9 million but it included about $3.7 million in one-time related expenses due to transitions from NutriSystem Nourish to our new food line, NutriSystem Advanced. David Clark will provide more details on that in a minute.

Full year results were quite good. Revenues of $777 million which is up 37% over the prior year, adjusted EBITDA of $173 million which is up 23% over 2006, EPS came into $2.96, up 29% from the prior year and our reactivation revenue came in at $95.5 million and that was up about a 152% over 2006.

Our strong revenue growth in the first half of 2007 moderated a bit in the back half of the year due to new competition. As we head into 2008 we believe some consumers are pulling back on discretionary type items and commercial weight loss products would fit into that category.

We are seeing a high single-digit to low double-digit drop in total starts in our business in the first six weeks. This is not first-time orders but total starts. Based on the research we've done thus far in 2008, we believe this is economy related and Joe Redling will have some additional color on the topic a bit later.

So although our start thus far in 2008 has not met our expectations, it doesn't change our view on the business. We will continue to operate this business with a view for the long-term. We believe the global opportunity for our company has been never been larger, and we expect to generate significant operating cash flow in 2008 and with no-debt, we will continue to take steps to optimize the return to our shareholders, including at the discretion of the Board, continuing the previously announced share buyback program.

With that, I'd like to turn the call over to David Clark, our CFO.

David Clark

Thanks Mike. For the full year of 2007 we generated $776,767,000 in revenues, which as Mike stated is a 37% increase over the prior year, reactivations generated $95,457,000 in highly profitable revenue for the year and we served 1.3 million customers in the year 2007.

Gross margin came in at just over 53% increasing 100 basis points since 2006 and marketing as a percent of sales was 23%, up from 21% in 2006.

The higher percentage stems from a full year of senior and mail-directed adverting campaign and some lower efficiency in the second half of the year. Operating income was a $162,854,000, 22% higher than 2006 and it represents a 21% operating margin.

Our adjusted EBITDA came in at a $172,653,000, which is up 23% from last year and non-cash compensation for the year totaled $4 million. Non-cash compensation is added back for the purposes of calculating adjusted EBITDA. That adjusted EBITDA margin was 22%.

Income from continuing operations was a $104,947,000, up 22%. The company decided to classify its Slim and Tone operation as discontinued and held for sale in the fourth quarter. And loss on those discontinued operations was $795, 000. Net income was further impacted by $800,000 in an equity loss in our affiliate ZeroWater and a small currency adjustment reflecting our new operations in Canada.

The company had a 36.7% tax rate for the year and diluted EPS came in for the year at $2.98 before discontinued operations and $2.96 after. Both were up 29% over the previous year. Non-cash stock compensation had a $0.07 impact on EPS for the year.

Customer acquisition costs or CAC for the year came in at a $184 as full year marketing spend reached a $175 million. Our direct channel generated 94% of our revenue, with 5% coming from QVC, QVC totaling $41 million for the year and the remaining 1% from other channels.

For the fourth quarter, we recorded a $137,189,000 in revenues, up 3% over the comparable quarter and gross margin was 50% versus 55% a year ago, reflecting the one-time expenses of $3.7 million incurred as a result of our transition from Nourish products to our new Advanced offering.

In order to complete that transition, we progressively consolidated our Nourish inventory down to just one distribution center by the end of Q4. This enabled us to build our Advanced inventory levels at the other five distribution centers in order to prepare for our January launch. But as a result, we incurred higher shipping costs and less efficiency in our fulfillment operations in the fourth quarter.

In addition, as we phased out individual Nourish items, we substituted Advanced products, which led to higher returns and higher obsolescence. As of January, we are only shipping Advanced products out of our direct channel and we anticipate working off our Nourish inventory through QVC and others through third parties through the second quarter.

Operating income for the fourth quarter was $15,942,000, down from just under $30 million for the same period in 2006. And as I said, operating income was impacted by $3.7 million of those transition costs to our Advanced product line. In addition the fourth quarter was also impacted by $900,000 of start-up costs in Canada and the full year was impacted by $1.4 million of start-up costs for Canada.

In addition, we saw a widening of marketing as a percentage of sales 24.8 % in the fourth quarter and higher G&A costs related to the redevelopment of a new e-commerce platform as well as share-based compensation of $1,410,000. Adjusted EBITDA for the quarter was $19,034,000.

Income from continuing operations came in at $11,263,000 versus $19,956,000 a year ago and the company recognized a loss from our ZeroWater affiliate of $800,000 and a small currency adjustment.

Our fourth quarter tax rate was just under 30% as the company benefitted from large food donations in the fourth quarter. Net income came in at $10,487,000 and our diluted EPS was $0.33 before discontinued operations and $0.31 afterwards.

In the fourth quarter, our marketing spend was $34 million which generated tax of $252 and revenue per customer was $648 for the nine months leading up to the end of the fourth quarter, which obviously leaves out the strong first quarter.

The comparative revenue per customer for the same period of 2006 was $632. Our heavy spending in the fourth quarter was directed toward the launch of our Advanced product line and the anticipated pick-up and diets starts in the fourth quarter.

As Mike mentioned and Joe will expand upon, we believe the economy is impacted a normally strong first quarter and consequently we're focusing on our media efficiency and reducing our spend in less profitable channels.

We are very pleased, however, with our revenue per customer and have seen consistent increases through 2007, reflecting a full year of our senior's and men's programs, including a men's price increase taken in the third quarter. Length of stay in the initial diet cycle stays between 10 and 11 weeks and we have a number of initiatives to increase that stay and increase reactivations.

All of our data suggested if we can get customers to stay on their first diet cycle for the second month, they are not only more profitable in the initial cycle but also far more likely to reactivate. From a liquidity standpoint we ended the year with $42 million in cash and marketable securities, as we built our inventories to $82 million by the end of the fourth quarter.

We entirely invested in money market accounts at this time and hold no auction rate securities. Our $200 million credit facility remains available should we need it. In the fourth quarter, we invested $14 million in ZeroWater and purchased $24 million in our own stock, which totaled 787,600 shares and stock buyback authorization of roughly $183 million remains in place. And in late November, given the increasing economic uncertainty and anticipating a build-up of Advanced inventory, we suspended any buyback activity through the balance of the year 2007.

Now to moving to guidance to put our guidance into some context. First, it is important to recognize that the first and second quarter of 2007 were particularly strong comparables especially as the new diet starts. With the economic and competitive pressure facing us in the current quarter, we are anticipating a much slower start this year.

With new starts in the first quarter carrying into the second and the second quarter carrying into the third, we are anticipating that our full year guidance will have a sequential increase in profitability for the first two quarters in year and then a full recovery in our adjusted EBITDA levels to the same levels we saw in the second half of 2007.

So specifically to our guidance, we expect revenues for the full year of 2008 between $690 million and $710 million and between $125 million and $135 million in adjusted EBITDA. We expect reactivations to contribute just over 20% of 2008 revenues. For the first quarter of 2008, we expect revenues to be between $200 million and $210 million and adjusted EBITDA to come between $18 million to $22 million.

We are expecting the current economic environment to cause lower customer counts versus first half of last year and expect to recover in the third and fourth quarter to the customer counts we saw in the second half of 2007. This guidance does reflect certain cost reduction initiatives, anticipation of flat revenue per customer and marketing spend calibrated around profitability.

We expect pressure on our gross margins based on rising food costs, a full year effect of our two weeks free promotion and rising freight costs. We are going through a comprehensive review of our supply chain to contain costs.

Given the economic environment, we are not modeling a price increase for the year 2008, although we will likely test one in the fist half. Our G&A as a percent of revenue came in at 8% in 2007 and was built around an expectation of about a $1 billion plus revenue run rate experienced in the first half of 2007. Consistent with our current expectations however, we have plans to bring G&A expense dollars down 10% to 15% over the course of the calendar year unless we see a faster economic recovery.

Our decision to guide to adjusted EBITDA is based on the fact that we will continue to recognize ZeroWater, Slim and Tone and currency fluctuations below the operating income line. An adjusted EBITDA will also permit us to add back volatile non-cash compensation expense to give a more consistent measure of profit performance.

Now a word about ongoing disclosure. As you have heard and will hear, our management is focusing on operating our company as a recurring revenue model that focuses not just on first-time customers but on generating maximum profitability over their time with us. Consequently, we will be directing increasing portions of our marketing and promotional spending toward extending length of stay and increasing the instance of reactivations.

Accordingly, we will measure our success on adjusted EBITDA generation and a consequent margin as compared to our revenue. And so consistent with subscriber-based businesses and we are also consistent with our peers commencing in the first quarter, we will shift more of our focus toward gross margin, marketing as a percentage of sales and adjusted EBITDA margin and you will see us move away from CAC, revenue per customer and other new customer focused metrics.

While we will to use these tactical metrics to make day-to-day operating decisions, we will have our strategic focus on long-term profitability. Although we have some economic headwinds to weather, we encourage by our business' flexibility and ability to react to change as well as the health of our balance sheet and our cash flow generation.

That concludes my remarks. And now I'll turn the call over to Joe Redling, our President.

Joe Redling

Thank you, David. As we outlined in the Q3 earnings call, we are entering 2008 with high expectations on reversing the trends we experienced in the second half of 2007. We expected a strong ramp in seasonal demand that we've normally seen in the first quarter and despite the anticipated heightened competitive environment, we expected to regain marketing efficiencies and accelerate new customer acquisitions.

Unfortunately, Q1 performance has fallen below our expectations. While the results are disappointing, we believe this trend is driven primarily by macroeconomic issues and not by any category or behavioral shifts in the business.

We have experienced the decline in marketing efficiencies in the first quarter, compared to both prior years and our own internal expectations for the first quarter of 2008. We continue to monitor and adjust spending levels to improve efficiency and maintain acceptable levels of ROI.

In addition, we made the conscious decision to continue to invest spend throughout January as competitive activity increased. We expect we will to see dividends from the spend in future quarters as we have seen strong growth in consideration and awareness as well as consistent growth in web traffic and sessions so far in Q1.

However, we are clearly seeing delays in decision making by consumers within the category. The normally anticipated spike in consumer purchase for diet products in the first quarter never truly materialized. While we saw consistent seasonal gains in consumer intent, that intent was not converted into sales at our expected levels.

As we witnessed this softness in demand, we immediately field the tracking studies to determine what was causing the weakness in demand. We set out to gain insights into all possible scenarios, including the economy, brand or product relevance, competitive factors or structural category shifts in either addressable market size or category shifts within the diet segment.

The result clearly reinforced the macroeconomic issues we are currently facing with today's consumers, but on a positive side also validated the continued strength of NutriSystem, the brand, our product in the addressable market. We have seen unaided awareness in overall consideration for the brand increased significantly.

Our market tracking studies indicate that our competitive position in the market remains strong, our customer satisfaction levels remain high and commercial weight loss category also remains healthy. However, the delay in purchasing was also noted with the primary factors driving this delay behavior being attributed to the economy, price and added confusion over a multitude of choices. All issues we must address as we move forward.

Operating in this environment will require us to be diligent and flexible in our approach to optimizing our results in 2008. The flexibility of our business model enables us to right size our cost structure and manage our variable spend in accordance with market trends. Our relevance in core product offering and brand not only remain healthy but continue to show strength and we will continue to evolve our offerings to improve results.

Let me share with you the key initiatives for 2008. First, as reactivation revenue continues to become a more important part of our revenue mix and a critical contributor to 2008 adjusted EBITDA, we will be increasing our marketing investment to support this growing segment.

We have seen continued strength in react revenue in Q1 and it appears it is minimally impacted by the economy factor as returning customers have a much higher value perception due to their previous experiences of success with our program.

As our business matures we must focus on driving lifetime revenue and using our marketing expertise to drive this highly profitable segment.

Second, revenue per customer and spending, as well as length of stay are also key economic drivers of our business. And we are in the process of developing new programs to address these opportunities. A new maintenance program is in development to extend our paying relationships beyond the initial weight loss phase and we are continuing with our expansion of our frozen line of entrees that we expect will increase revenue per customer and length of stay. We expect our frozen line will be ready for testing by mid-summer.

To address the current economic challenge, we are testing a number of new offers and value enhancement to give dieting consumers a better reason to try us in these uncertain times. We believe we have a number of value driven options to introduce new entry price points or promotional programs that can drive incremental new business.

Our newest offering will be a 3-week free offer which offers customers a free week for each of their first three months of use. Our initial test results have been positive, as we have tested head-to-head with our current controls and have seen improvement. The intent of the revised offer is to both improve front-end conversions and our overall marketing efficiency.

In addition our new e-commerce platform will enable us to be more efficient in testing and in offering new promotional programs dynamically to optimize overall profitability. We will also be launching [new creative] as we will feature our new spokes people Marie Osmond and Larry the Cable Guy.

We will continue to manage our media spend to optimize profitability on our new customer efforts. We will sharpen our focus on multi-channel management to make sure we are capitalizing on all efficiencies and are getting more from every marketing dollar spend.

On the international front, our initial launch into Canada has exceeded our expectations and we will continue to drive investment there as we are seeing excellent returns. We will continue to focus on expanding into new markets and doing the necessary work in 2008 to further diversify geographically in 2009.

We are also continuing on our commitment and investment to support the aforementioned e-commerce platform. We are seeing increased traffic in the natural growth of current and prospective customers using our website. Due to the increasing ambiguity of the NutriSystem brand, more consumers are naturally migrating to our direct domain using NutriSystem.com as their primary navigational source.

We must focus on improving conversion as more consumers browse and shop for diet options online. As we complete work on the e-commerce platform in Q1, we will be moving into the second phase with significant improvements of our front-end consumer facing site design and functionality in Q2. We will also be addressing customer service applications which will enable us to service many of our customers needs online and reduce our cost on the call center side of the business.

As David said on the cost side, we are initiating a cost reduction program to right size our cost structure for our revised 2008 plan. Our business continues be an asset like business and we have a great deal of flexibility to continue to keep our cost in line with our top line trend. We absolutely will do the right thing to manage our expenses appropriately in 2008.

I remain confident in our business. We are managing through a difficult economic period but underlying indicators remain healthy. We will continue to invest in our brand, manage our resources efficiently and continue to innovate to do everything we can to optimize our results throughout 2008.

We have opportunity ahead of us as we continue to leverage our marketing platform to address this ever growing global market. Thank you.

And now, I'll hand it over back to Mike.

Mike Hagan

Thanks, Joe. Just to recap some of the more important things we've been talking about. Marketing efficiency thus far in 2008 while it hasn't been what we are accustomed to seeing in prior years, has still been profitable. What are we doing about it? Well, we are coming out with [new creative], as Joe just mentioned that will focus more on value with the new offer and we've got some exciting new celebrities to help us make that pitch in Larry the Cable Guy and Marie Osmond.

Number two, our reactivation trends continue to be solid in Q4 and the first six weeks of the year. That is one of the many reasons that convince us everyday that we are building something very enduring.

Third, our Canadian business is off to a good start. We expect to grow our international footprint in to Europe and Japan next year. And four, we expect to generate significant operating cash flow this year and with our existing cash, we have much flexibility in how we can return value to our shareholders.

And with that operator, we would like to open it up for some questions.

Question-and-Answer-Session

(Operator Instructions). Your first question comes from the line of Greg Badishkanian of Citigroup. Please proceed, sir.

Greg Badishkanian - Citigroup

Great, thanks. Hey just a few questions here. First one is just to understand first quarter looking for EBITDA of about $18 million to $22 million. For the full year, it is $125 million to $135 million that kind of implies improved profitability throughout the year, first quarter is seasonally stronger. Is that just when comparisons get easier in the second half; profitability should improve?

Mike Hagan

There are three things going on there, Greg. Yeah, the second half of the year comps for 2007 get quite a bit easier, as we expected. When you get the comparisons against what we consider to be a very acute competitive issue in Q3, we think we will see better efficiency in our marketing.

But the first half of the year, we went into 2008 with a very strategic decision, we are going to invest in the new product launch, NutriSystem Advanced. So we had a significant amount of marketing dollars that we put in place, mostly in January where the approach was different, than how we approached marketing in the past, which was all about the accountability ROI of the advertising.

So January spend was significantly higher on a year-over-year basis and a lot of that spend was it looked at from an ROI standpoint, the way that we've looked at advertising spend in the past.

When you strip that out and you begin to look at how the marketing efficiency, especially over the last few weeks, has improved and is getting more profitable, albeit we're reducing some of the unprofitable marketing spend of January, so we expect to see better patterns in the coming weeks. We certainly have seen it over the last two or three weeks.

And then when you get into Q2, obviously you have the tail effect from Q1 where you acquire a lot of customers and you get the second, third and fourth orders out of those customers.

Gregory Badishkanian - Citigroup

Right. And just kind of looking at the economy and the impact, I mean your diet plan is $300 even though it's $10 a day, so that's a big ticket item. What are consumers doing instead, are they just delaying purchases? Are they going to Weight Watchers or what is your analysis showing?

Joe Redling

Greg, it's Joe, our analysis is showing that there is clearly a debt delay that we are seeing across the category. We haven't seen any type of competitive share shifts. There is a high level of intent on the consumer front that we track from Q4 to Q1 in terms of those dieters that are planning to go on a diet but there's been a pretty dramatic drop in actually making the diet purchase.

We haven't seen shifts in the category within commercial weight loss to other categories. Each of the segments is retaining their expected share. So we don't think there is a competitive advantage going on in the market. We just believe that there is an overall dampening of the buying behavior that we are seeing from dieters.

Greg Badishkanian - Citigroup

Okay. Good. That's helpful. And Alli, I'm assuming you are hearing a lot less, even though it is still taking some share. What's your thought there?

Mike Hagan

Yeah, we think it's moderated quite a bit from what we saw in the third quarter and the fourth quarter. Obviously, we listened very intently to our customer calls and we didn’t hear a lot of activity regarding the product.

So, we don't think it's having an impact on current trends right now. You could say that they are selling products, they are moving some volumes still if you track their data. So, a percentage of those customers might have considered NutriSystem, but we don't think it's a significant part of the trends we are seeing.

Greg Badishkanian - Citigroup

All right, good. And finally, reactivations, it seemed strong in the fourth quarter, and like Mike said, it's very strong. What percentage of your business do you think that could be in 2008? And do you have any color in terms of maybe, looking at your most mature segment, women's, are there any additional colors that you've learned over the last few months?

David Clark

Greg, it's David. The revenue percentage will be probably something north of 20% in terms of contribution from reactivation revenues. As to the behavior amongst segments, I don't…

Mike Hagan

I mean I think the real takeaway of reactivation is encouraging; as we talk about Q3, we made a statement that the react revenue was not impacted by competitive activity by Alli. You would obviously have a question of what the economic impact of these customers going forward with this type of economy would be and we've seen continued strength in that business.

And again our hypothesis that I mentioned in my remarks is that these are customers who understand our product very well. They understand the value because they have been successful on it. So they are not really experiencing the price point for the first time. So they return because the program works. So that's encouraging to see continue through the first half of the first quarter and we expect that to continue in 2008.

Greg Badishkanian - Citigroup

All right. And in terms of economics, it’s still pennies on the dollar, relative to acquiring new customer?

Mike Hagan

Yeah. I mean we expect to invest in that segment, the profitability is huge. The more we can impact that reactivation trend, the better off our business is. So that's why we look at our overall spend differently going forward as that revenue becomes a bigger part of our mix. We have to really contemplate our overall marketing spend as driving both new customers as well as reactivations.

Greg Badishkanian - Citigroup

Great. Okay. Thank you very much.

Operator

Your next question comes from the line of Colin Sebastian of Lazard Capital Markets. Please proceed, sir.

Colin Sebastian - Lazard Capital Markets

Thanks Mike. Thanks for taking my question. Mike or Tom you have had a couple of quarters now in your belt with Alli in the marketplace. So I guess my first question is from marketing perspective, aside from the consumer issues you're saying macro-related issues. Do you feel you found a way to counteract some of the competitive pressures? I do have a couple of follow-ups.

Mike Hagan

Well, we did, I mean our hypothesis back in Q3, was that we had to weather the storm with the Alli issue and it was sort of much bigger issue back in Q3. We were prepared to react if we thought that that was the issue heading into 2008 with some kind of messages to address that.

If we're looking at some softness in 2008, we think that that third or fourth in terms of the reason behind it and we do see the Alli customer overlap which is profile of our customer; but we just don't see the kind of numbers and anecdotally, we just don't see a lot of people calling into our call center asking questions about how Alli complements or replaces our program. We just have seen that volume really dissipate quite rapidly in the last three months. So we really didn't have to tweak our advertising message as we headed into 2008.

Certainly we're prepared to tweak it now, to focus more on value to look at that $10 or $11 a day and look at it compared to what our customers are already spending for the meals. And so that is in the work, so we expect by the end of the month you're going to see some new campaign certainly by early March, new campaigns focusing on that value message.

We already had the three week offer out there in TV. It had some success in print over the weekend. So we're encouraged that consumers are focused on that three week free offer, if they're looking to lose a lot of weight, obviously they only get that extra week if they accept that third month in the weight loss system.

Colin Sebastian - Lazard Capital Markets

Okay. And then as it relates to shift in the marketing spend, should we infer from that it will be more of a waiting on e-mail or direct mail campaigns and less on the traditional via television and I guess that relates then to the reactivation business. I was just wondering if you could perhaps quantify what contribution you are expecting from that group over the course of the year?

David Clark

I do believe that we are going to be spending more of our resources on e-mail and database marketing, specifically as we launch our new e-commerce platform as well, it will allow us to reach our customers in a more dynamic way than we've ever had before.

And it certainly will improve the efficiencies of our marketing spend. Now that being said, we still will invest heavily in those channels, including TV in areas that continue to perform very well and acceptable ROI for us.

Colin Sebastian - Lazard Capital Markets

Okay. I guess and my question then is, initial takeaways from NutriSystem Advanced, are you pleased with the program as you've formulated it, or any tweaking beyond just the marketing message that you plan to do there? Thank you.

Joe Redling

I think overall we are pleased with the product itself. It's a much better product, healthier for the customer, it's easier for the customer to follow and start. I think some of the reactivation revenue that you are seeing, specifically towards the end of December and January, it's probably a testament to the fact that we do have a new program that consumers are gravitating towards. Our satisfaction scores with the program so far have been very high, it's been well received and all in all, I'd say that we are happy with it.

Colin Sebastian - Lazard Capital Markets

Okay. Thank you.

Operator

Your next question comes from the line of Vivian Ma of Oppenheimer. Please proceed, madam.

Vivian Ma - Oppenheimer & Co.

Just a quick question on gross margin; it was a little bit lower than I thought. I'm just wondering, is there anything that changed in terms of the cost of the revenues and what is the outlook for '08?

David Clark

Well, the fourth quarter was affected pretty much primarily by the transitional items that I mentioned in terms of operating our distribution centers really in a bifurcated fashion with a few handling fulfillment of the continued orders on Nourish and the rest really stocking up in anticipation of launching Advanced.

So you had a less efficient distribution system in the fourth quarter and also because we are doing substitutions as we began to run down the supply of individual Nourish products, those substitutions led to higher customer returns and higher obsolescence. So that is behind us.

But going forward in terms of the way we are forecasting the business, we are building in an anticipation of higher food costs that are out there. It is not a mystery to anybody that higher dairy costs and related food products are affecting the economy and also higher freight costs mostly tied to higher energy costs.

So that is the really the trend going forward. There is an effect of running a full year of the two weeks free promotion. But the two primary drivers are higher food costs and higher freight.

Vivian Ma - Oppenheimer & Co.

Okay. Great. And also for tax rate for 2008, is 37, 38 an appropriate level for you?

Mike Hagan

Yeah, I would say not higher than 37. I would say 36 to 37.

Vivian Ma - Oppenheimer & Co.

Okay. And just my last question is with regard to the Canada, you mentioned that the initial response is very favorable. Is it a much faster ramp than I guess when NutriSystem was repositioned back several years ago in this market?

Mike Hagan

We expect it to get to the 10% kind of revenues at the U.S. business quicker than we realized, quicker than we expected, so yeah it's still low single-digit today but we expect by 2009 will be between 8% and 10% of U.S. revenues. So in the second year, we expect to get there.

Vivian Ma - Oppenheimer & Co.

Thank you very much.

Operator

Your next question comes from the line of Jim Duffy of Thomas Weisel. Please proceed sir.

Jim Duffy - Thomas Weisel Partners

Hi, there. My questions have actually been answered.

Operator

Your final question comes from the line of Laura Richardson of BB&T. Please proceed ma'am.

Laura Richardson - BB&T Capital Markets

Thanks. Just wanted to take it a little deeper on your guidance. And in Q1, it looks like the revenue guidance is down maybe 16% from last year, but if you look at the operating income or EBITDA, it's down more like 65%. And I thought from what you just said about cost of goods, that's not going to be the biggest cost pressure in Q1. So can you point out what is going to be the biggest cost pressure, and then why that dissipates as the year progresses?

Mike Hagan

As I mentioned, Laura, to an earlier question, I think that the biggest chunk of money gets to the brand building of NutriSystem Advanced that really went out of the door in January but didn't have the kind of accountable ROI that we earmarked most of our advertising dollars for.

So that is the sort of the one-time item that really represents the biggest impact other than the negative operating leverage because of lower revenues and higher G&A. We expect that the G&A, as David mentioned G&A will come down by Q2 quite a bit, probably in the order of 20% versus Q1 levels but marketing is the biggest reason, not what's happening in our cost of goods.

Laura Richardson - BB&T Capital Markets

Okay, that helps. And then, let's say testing the frozen program happens this year and then you have a launch of that next year, your plan for that ideally? And do you have the same kind of brand building that you need to do next year?

Joe Redling

No, I think the plan for frozen is to launch that this fall to our existing customer base. We'll be testing in mid summer in terms of price points and positioning and branding for that line and we are going to get it out as soon as we can, because we do think it will have a nice impact to provide additional variety and drive the length of stays.

So we want to get it to our existing customer base as fast as we can. We expect it to be a component as we move into Q1 to increase the variety and choices of our consumers and make their initial package purchases and customization even more robust.

And so we probably will not go out and do a standalone frozen line marketing campaign, but we will integrate it as a component of our overall messaging.

Laura Richardson - BB&T Capital Markets

Okay. Thanks a lot.

Mike Hagan

Thank you.

Operator

Your next question comes from the line of Bill Sutherland of Boenning & Scattergood. Please proceed, sir.

Bill Sutherland - Boenning & Scattergood

Thank you. Do you all have in mind a sense of where length of stay can be pushed to in your business?

Joe Redling

We think that there is a top end of a couple of extra weeks as you layer this new effort in. We've increased length of stay pretty significantly every year. This is the first year we've hit a ceiling, so that's why we believe we need to do something substantial for the product and we think frozen is one, as well as maintenance.

Not just extending the initial diet cycle is continuing a billable relationship with our customers. And we think maintenance is a big opportunity, we haven't really put a major focus on our maintenance program until now, as we again get reinforced about no focus on revenue per customer and reactivations.

So we believe the combination of these programs will drive revenue to the customers. So we do think there is an opportunity to grow that number over time. We don't think we're going to get in a quick ramp up. I mean, that's the number that takes time to grow on average. We got to take it kind of one step at a time, but we do think there is an opportunity to grow it.

Bill Sutherland - Boenning & Scattergood

Okay. I know share comp expense is nothing you can nail down very closely, but what's a good working number for '08?

Mike Hagan

The share comp expense, I mean if you want to put a pin in it, you can put sort of $7 million number on it. As I said that does fluctuate with stock prices.

Bill Sutherland - Boenning & Scattergood

All right. Sure. And then what's the ending share count for the year?

Mike Hagan

Just over 34 million shares. You want it exactly?

Bill Sutherland - Boenning & Scattergood

I'll get it in the file. And then finally, I was pleasantly surprised by the equity in loss of affiliate line. What's the outlook for ZeroWater?

Joe Redling

We're excited about it, I mean it's early. We're going through this kind of first phase of cross selling, but I think the bigger excitement builds when we launched their TV spots and their print campaign. So that is maybe a couple of months away on both print and TV, but we continue to be excited about the business.

Bill Sutherland - Boenning & Scattergood

So, is that loss number going to bounce around as a function of bringing initiatives like that, Mike?

Mike Hagan

It will Bill, and that's one of the reasons why we're focusing on adjusted EBITDA and that's sort of below the line. We did have $800,000 loss on that in Q4 but that will bounce around a little bit.

Bill Sutherland - Boenning & Scattergood

Okay. Thanks everybody.

Operator

And we have a follow-up question from the line of Greg Badishkanian of Citigroup. Please proceed, sir.

Greg Badishkanian - Citigroup

Quickly, just following up, you had mentioned low single-digits for Canada, and I'm wondering if you could kind of update your strategy on the UK, and obviously you've some good inroads in Canada, is that giving you a little bit better confidence that you can penetrate that pretty big market over the next few years?

Joe Redling

We do have some confidence with the Canadian launch and we do believe that it will be high single digit to 10% of our revenues next year in Canada. With Japan, we're getting close to announcing something, would expect something in the next few months. We've been working hard on this joint venture and a lot of the heavy lifting has been done by our partner already, but we expect to be driving revenues there in 2009 even by the first quarter of 2009.

With UK at this point, we expect to do it alone and we're in the process of hiring a general manager and that will take a little bit of time but we expect to be driving revenues there by the second half of 2009. So we're not going to just try and go live by January 1, just hit the diet season, we're going to do it in the right way with the right menu, with the right infrastructure in place and we view that market as a very big opportunity for us.

Greg Badishkanian - Citigroup

Great, thank you.

Operator

This concludes our Q&A session. I will now turn the call over to Mr. Michael Hagan for closing remarks.

Mike Hagan

We'd like to thank everyone for their time and we hope that you'll join us in April for our next conference call when we discuss our first quarter results.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!