NutriSystem Corporation Q1 2008 Earnings Call Transcript

NutriSystem, Inc. (NTRI)

Q1 2008 Earnings Call

April 23, 2008 5:00 pm ET

Executives

Michael Hagen - Chairman

Joseph Redling – President & CEO-Elect

Thomas Connerty – Executive VP & CMO

David Clark - CFO

Analysts

Greg Badishkanian - Citigroup

Colin Sebastian - Lazard Capital Markets

William Sutherland - Boenning & Scattergood

Laura Richardson - BB&T Capital Markets

Karen Howland - Lehman Brothers

Nicole Jacoby - Liberation Investment Group

Presentation

Operator

Good day ladies and gentlemen and welcome to the first quarter 2008 NutriSystem earnings conference call. (Operator Instructions) I would now like to turn the presentation over to Mr. David Clark, CFO; please proceed.

David Clark

Good afternoon everyone and thank you for joining us to discuss NutriSystem’s first quarter 2008 financial results. With us today from management are Michael Hagen, Chairman; Joseph Redling, President and Chief Executive Officer-Elect; Thomas Connerty, Chief Marketing Officer and Executive Vice President of Program Development; and I’m 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 first 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 second quarter of 2008 and the full year 2008, its expectations regarding the affect of the economy on customer spending and similar statements that are not statements of historical constitute forward-looking statements. For such statements NutriSystem claims protection of the Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from the results predicted and the reported results should not be considered as an indication of future performance.

Factors that could cause actual results to differ from those contained in the forward-looking statements include but are not limited to those factors set forth in NutriSystem’s Annual Report on Form 10-K for the year ended December 31, 2007 which has been filed with the SEC. NutriSystem is making these statements as of April 23, 2008 and assumes no obligation to publically update or revise any of the forward-looking information in this announcement.

And with that I would like to turn the call over to Michael Hagen, our Chairman.

Michael Hagen

Thank you David. Good afternoon and thank you for joining us on today’s conference call. First I’d to reiterate the upcoming management transition we announced on April 8, 2008 and then provide a few comments on 2008. Next Joseph Redling will provide you with our Q1 2008 results and update the progress on our growth initiatives. Then David Clark will take you through a detailed view of our financials for the quarter. At the conclusion of David’s remarks, we’ll open it up for questions. Thomas Connerty, our Chief Marketing Officer is here with us as well for Q&A.

As we had previously released effective May 1, 2008, Joseph Redling will succeed me as CEO and he was elected to the Board of Directors effective April 7, 2008. On May 1, I will become the Non-Executive Chairman of the Board and remain an employee of the company. It has been a privilege to be the CEO of this company over these last six years. I’ve enjoyed every minute of it and I feel really quite proud of what our team has accomplished. In a relatively short period of time we’ve taken NutriSystem from a $25 million business to one that’s driving more than $700 million in sales and a business that’s very profitable.

Most importantly we have affected the lives of more than 2.5 million people in this country in a healthy and positive way. Customer satisfaction comes from product efficacy and superior customer service and we have both here at NutriSystem. The enduring nature of our business will be our teams’ legacy and I couldn’t be more thrilled in turning the reins over to Joseph Redling, our company’s next Chief Executive Officer. I will continue to stay involved in the business and work with Joe in the areas of strategy and business development.

I have spent the last eight months working side-by-side with Joe and I have to say I have been very impressed. Joe’s obvious talents are in the area of product innovation, marketing and customer acquisition, but as you can see by our first quarter results, Joe has been making steady improvements in the total customer experience. This shows up in terms of better-that-expected retention and reactivation rates and thereby improving on our customer economics. We both feel there is much more progress to be made but we are off to a good start.

In a move that takes advantage of our strong cash position and healthy balance sheet, I am pleased to announce that the Board of Directors has declared a quarterly dividend of $0.17.5 per share payable May 15, 2008 to shareholders of record as of May 5, 2208. Importantly the company intends to continue to pay regular dividends. However, the declaration and payment of future dividends are discretionary and will be subject to determination by the Board of Directors each quarter following its review of the company’s financial performance. David will go into more details on that in a few minutes.

Now I will turn it over to Joe to further provide details on a better-than-anticipated first quarter.

Joseph Redling

Thanks Mike. Let me also take this opportunity to say thank you Mike on behalf of myself, our management team and all NutriSystem employees. Your tremendous vision and leadership over the last six years has resulted in the creation of a great business, a great brand and a solid foundation for growth. On a personal note, I truly value your support, counsel and friendship and I look forward to building on our relationship in the years to come. Thanks again Mike.

Now let’s dive into first quarter results, revenues came in at $216 million, down 9% versus a strong Q1 2007. Gross margin for the first quarter was 50.5% which represents a decline of close to 300 basis points compared to prior year, due primarily to increased cost of food and transportation. Adjusted EBITDA was $26.6 million, down versus prior year reflecting the incremental marketing investment of $15.6 million versus a year ago and the continued pressure on the gross margin line. Operating income came in at approximately $23.4 million.

After a tough start in January, improved marketing efficiency later in the quarter along with improved customer retention and stable reactivation revenue resulted in a first quarter that was better than anticipated. Revenues were $216 million compared with our guidance of $200 million to $210 million. There is no doubt that the weakening economy has had an impact on our customers’ purchase decisions in the quarter. We continued our tracking of economy-related obstacles with our potential consumers and saw our consumers continue to be influenced by their near term economic fears throughout Q1. However we did initiative programs to counter these factors that enabled us to improve our performance in the second half of Q1.

I will expand on this in a moment, but first let me address the gross margin challenge. As you have heard from many business sectors, price increases in food and transportation are impacting gross margins. While we have been successful over the past few years leveraging our scale and holding costs in check, 2008 has proven to be a true challenge. While we continue to drive efficiencies in other supply chain areas, they are not enough to offset the gross margin impact of the increased food and transportation costs.

We are continuing to focus on this area and are working in partnership with our vendors to apply cost-saving measures and to do the best we can to mitigate this challenge. You will recall that we did not implement a price increase at the beginning of this year as we continued to strive to provide value to the customer in this difficult economic climate. However we do plan on initiating price testing later in the year to measure the feasibility of selected price increases to improve our margins. We will also be monitoring our customer trends to be ready to act if we see stabilization in the economy where the environment for price increases may be more acceptable.

While we beat our adjusted EBITDA guidance for Q1 by more than 20%, this performance was negatively impacted by both our gross margin pressure as well as our decision in January to continue to strategically invest early on in our marketing effort. Marketing spend as a percentage of revenue peaked at 31% for the quarter, as compared with 22% a year ago. This incremental spend of $15.6 million was initiated with two primary objectives in mind. The first was to maintain a strong competitive share-of-voice in the highest demand quarter in the year during what we anticipated to be a heightened competitive media environment.

Secondly it was our intention to seed and support the launch of our new product; NutriSystem Advance. Clearly category spending reached an all-time high in Q1. By our estimates media spending for the entire category was the highest it has ever been and this created a great deal of noise within the category. While this level of category spend did we believe create delays in purchase decisions, our investment in media did result in continued increases and NutriSystem unaided brand awareness and consideration, that played a key role in stabilizing our performance during the latter half of the quarter.

As we entered February we began to revise and prioritize our spend to respond to the business trends. While we believed it was important to allow our initial investment to play out in January, we did quickly respond and reallocate resources to our highest performing channels and media outlets that began to immediately improve our overall marketing efficiency. Looking forward marketing spend as a percentage of revenue will fall back in line with historical trends with full year spending returning to low to mid 20% range.

Let me spend a moment on our new product. NutriSystem Advance is performing well and has been widely embraced by our current customers and prospective customers. NutriSystem Advance included an improved flavor profile, enhanced nutritional value and improved exercise and behavior modification components. We also added new packaging by meal occasion and new welcome kits to continue to improve ease and convenience of our core offering. This created a greater value proposition for the consumer and we are seeing higher retention rates on our second and third orders of the new program.

We continue to have three strong core programs that appeal to a broad stratification of the weight loss market. In the first quarter of this year we have successfully launched new advertising campaigns to each segment. We are able to rollout our NutriSystem Silver campaign featuring Tony Orlando. Tony lost more than 100 lbs. on the program and is an effusive cheerleader for NutriSystem. Additionally we launched a new campaign featuring comedian featuring Larry The Cable Guy, touting our NutriSystem For Men program. Also, Marie Osmond became the latest spokesperson for our core customer; women aged 35 to 55.

As previously discussed like many other businesses, NutriSystem has felt the impact of the current economic condition. We have been very proactive in not only how we manage our spend in the challenging environment but how we innovate and address cost-driven objections. We were able to implement two important changes to our business towards the latter half of the quarter to connect with value-conscious consumers.

First we conducted a test in the first quarter that offered three weeks of free NutriSystem meals instead of our traditional two-week free offer. We tested this new offer in our television commercials, infomercial program and magazine ads. In this test we deliver one free week to accompany the first three shipments that our customer receives. We designed this offer to have a positive impact on our customer’s length-of-stay and are pleased with the results we have seen to date. Early results have been extremely positive improving conversion by as much as 50% in some of our media channels. Going forward we will continue to be disciplined in our measurement of the effectiveness of this offer as we extend it to other channels by direct mail and e-commerce advertising.

Additionally we launched a lower priced program for the customer to try called our 5-Day Flex Plan. The 5-Day Flex Plan gives the customer a monthly program that consists of 20 days of food and a meal planner for the remaining eight days that is priced $100 less than our standard 28-day program. This allows us to give the customer program that is best suited for their current budget without sacrificing their potential for losing weight. Although we are in the early stages of testing this plan we are very hopeful that it will help drive conversion of new customers and keep customers who are considering cancelling the program because of price objections, an opportunity to stick with NutriSystem.

We continue to be a learning organization that perpetually tests and we are continuing to evaluate additional value-based creative and promotional programs that will enable us to deliver a strong value message across our many consumer-touch points. Through disciplined testing we obtain great information about our customers’ behavior and we optimize that knowledge to improve business performance. Every decision we make regarding changes to media mix, product offering, creative execution and even pricing, is done step-by-step and by taking measured risks that give us valid data that we can extrapolate from.

One such test we conducted dealt with improving the organization, presentation and packaging of the food that the customer receives with the 28-day program purchase. During that test we were able to organize the product in the box by meal occasion and even separate out the free week that the customer receives with that first purchase. Our intent was to provide a much improved, opening-box experience. Our initial results are encouraging. Test results show that the improved organization and presentation clearly increased first-order retention. So we believe this effort will have a positive impact on customer retention and lifetime value as we roll it out to an expanded customer base.

We continue to focus on enhancing the customer on-boarding process. We know that successful weight loss results drive retention and lifetime value of our customers and we will be allocating additional management resources to this effort going forward.

Now let’s talk about our ongoing relationship with QVC, NutriSystem sales on QVC experienced performance trends similar to that of our direct business in the first quarter. Our January performance was disappointing but the performance showed healthy improvement over the second half of the quarter. The launch of the Advance program with QVC started in April. We had a very successful Advance introduction and actually sold-out all of the available inventory during the anniversary programming on the network earlier this month. Sales have been so robust on the network that we have been granted a second Today’s Special Value slated for July of this year. This is the third year in a row that we have granted a second airing of a TSV and it is a testament to the strength of our brand and the popularity and efficacy of our program.

Going forward we see improvement in marketing efficiency in the US business and will continue to invest our marketing dollars judiciously with a focus on maximizing profitability and enhancing learning and creative to drive both demand and conversion. While we will continue to stay focused on the core business we will also prioritize and support our growth initiatives.

Let me provide a few highlights. First we have previously discussed the strategic investment in our new e-commerce platform and web initiatives. We are in the final testing of our new e-commerce platform and are in the process of transferring all current customer data to the new platform. We expect the transfer to be completed by the end of May when the platform will be fully operational and will provide us with a much improved back-end infrastructure. This will enable us to continue to scale and significantly enhance our sales efforts and customer support functions.

In addition the complete redesign of our website and sales funnel continue and we expect to launch new web experience towards the end of the second quarter with continued updates and improvements scheduled through Q3. This is important work that will provide us with more robust publishing, testing and measurement capabilities to support our vision of a scaled, world class e-commerce business.

Other key initiatives include the continued support and development of the NutriSystem Frozen line of entrees and our new maintenance program that we expect will have a positive impact on both customer length of stay and revenue per customer. Both product initiatives are planned for test-rollout late summer of 2008.

Moving to international, we remain encouraged with the results of our first international expansion into Canada. The Canadian launch continues to move forward with website improvements and an efficient marketing plan that is expanding the advertising channels we use to reach the Canadian customers building on the momentum from television and print. Our expansion into the UK market also progresses and we plan to enter the UK market in the latter half of 2009. We are also pleased with our pace in entering the Japanese market through strategic partnerships.

In closing I’d to say I believe we are in a good position to continue to deliver strong results in Q2 and the second half of 2008. We have a very talented and focused management team and remain confident that our new initiatives, strong trends in revenue per customer and length of stay bode well for future growth in 2009 and beyond.

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

David Clark

Thank you Joe. For the first quarter of 2008 we generated $216,468,000 in revenues, a 9% decrease over prior year. Reactivations are trending slightly better than expected and we generated just under $40 million in highly profitable revenue so far for the year. Gross margin came in at 50.5%, a drop of 268 basis points versus the first quarter of 2007 due to the anticipated pressures around food and freight costs. Marketing as a percent of sales was 31% in Q1, up from 22% in the first quarter of 2007 which Joe had previously mentioned.

Operating income was $23,424,000 and represented a 10.8% operating margin. Our adjusted EBITDA came in at $26.6 million and our non-cash stock compensation totaled $1.4 million. Our adjusted EBITDA margin was 12.3% and income from continuing operations was $14,121,000.

For the below-the-line items, Slim and Tone posted a discontinued operations loss of $24,000 and our investments in the development of Zero Water resulted in a loss recognize of $1.2 million for the quarter, and finally we have $40,000 in other expenses which represented the negative impact from currency valuations with our Canadian operations.

The company has accrued for a 37% tax rate so far through the year and diluted EPS came in at $0.42, down 59.6% versus a year ago and the adjusted EPS adjusted for the buyback as if it had occurred in the beginning of the quarter would have been $0.46. Non-cash stock compensation had a $0.025 impact on EPS or the $1.4 million in total I mentioned earlier.

Our direct channel generated 93% of our revenue, and QVC generated 6% totaling $14 million from that channel and the remaining 1% from other channels.

Currently, we have $3.7 million of Nourish inventory on hand, down from $5.3 million at the end of the first quarter and we have been reducing this inventory in three ways. The first is fulfilling the QVC Summer Shape-Up Auto Ship program that went on a one-time only sale in March with great success. Second, we have an active clearance center on our website that select customers have access to. And third in the first quarter we created a relationship with a distributor who places the product with outlets such as Big Lots or grocery outlets.

In the first quarter, we repurchased approximately $45 million of our own stock, which totaled 3.3 million shares or almost 10% of the outstanding. A stock buyback authorization of roughly $138 million remains in place, and we currently have approximately 31 million shares issued.

From a liquidity standpoint, we ended the quarter with $43 million in cash and marketable securities and we continue to be invested entirely in money market accounts and hold auction rate securities. Our unused $200 million credit facility remains available should we need it. This business generates free cash flow that can sustain the aforementioned common dividend, which is approximately one-third of our net income and a smaller portion of our overall total free cash flow.

This dividend returns a 3.3% annualized dividend yield on a $21 share price, while allowing sufficient liquidity to opportunistically repurchase shares and most importantly having a large portion of free cash available to make investments in growing our business.

Now moving to guidance, we are increasing our full-year revenue guidance to between $700 million to $720 million. Our adjusted EBITDA guidance remains unchanged at $125 million to $135 million as we continue to see pressures from the cost of food and transportation, as well as G&A expenses from investments in our growth initiatives.

Q2 revenues look to be between a $180 million and a $190 million and we expect EBITDA for the second quarter to be $36 million to $40 million.

I will close with the reminder that with the new fiscal year, we have changed our disclosure to gross margin, marketing as a percentage of sale, and adjusted EBITDA and away from customer acquisition cost, revenue per customer and new customer metrics. These metrics are designed to be [inaudible] with cross subscriber based businesses.

Thank you and I will now turn it back over to Mike.

Michael Hagan

Thanks David. Before we open it up to Q&A, I would like to highlight a few important themes coming out of today’s call. As many of you know the pillars for our growth over these last few years had been threefold; create a product that is efficacious and convenient and allows our customers to be successful in reaching their goal weight. Two investing profitable advertising campaigns across a wide variety of marketing channels and three, provide superior customer service and counseling.

Underlying and fueling our growth has been our success in segmenting the weight loss market. The success in our original women’s market led us to pursue the men’s weight loss market and then the seniors. Each of these segments represented a significant part of our revenues and cash flow in 2007, as well as providing some diversity in our business along the way. Now here we are in 2008 and the next chapter is now beginning. Simply put the platform is evolving and expanding from a single-product company serving multiple market segments to a multi-product company that provides everything from weight loss to weight maintenance, as well as products with lower price points for price sensitive customers to higher price points for customers that desire more sumptuous eating experience and who have a higher household income.

The expansion of the platform in this way, we believe, will allow us to expand each of the segments we operate in from a household income standpoint and will allow us to improve on our customer economics thus driving better lifetime value metrics.

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

Question-and-Answer Session

Operator

Your first question comes from Greg Badishkanian - Citigroup

Gregory Badishkanian - Citigroup

Congratulations Joe and really nice work over the last several years in turning around the business Mike. Just a few questions here; first you mentioned that EBITDA guidance was basically unchanged although revenue guidance was increased, is that just due to increasing food and transportation costs or is there anything else to that that I’m missing?

David Clark

No, that’s primarily due to the anticipated continued pressures from increasing food cost and transportation.

Gregory Badishkanian - Citigroup

Okay.

Mike Hagan

And Greg, I would mention that you know the price tests that Joe mentioned are factored into the guidance, so if we’re successful in testing some of these price increases like we have in the past that would be added in.

Joseph Redling

We’re also again in our forecast because we’re -- will be in the test mode, in the second half of the year for maintenance and frozen, we also don’t have any forecast for any incremental revenue that comes from that as well.

Gregory Badishkanian - Citigroup

Okay, which leads me to, the margin impact from maintenance and frozen as - I’m assuming that’s lower, but it’s going to add incremental sales, is that kind of how you’re viewing that?

Mike Hagan

Yeah actually, the margin on the maintenance program is actually higher than our core program. So the maintenance program has very little hard costs to us versus our existing inventory. Frozen we’re striving to maintain the margins on the frozen line. The entree costs are relatively in line with what we do. Really the big change in the costs on the frozen line is really the shipping costs, which we’ll be passing through to the consumer. So our goal is to maintain margins as we see and of core shelf stable product with frozen and hopefully improve margins over time as we see the maintenance program.

Gregory Badishkanian - Citigroup

Okay good and then just looking my model, it looks like you beat guidance for the first quarter, 2Q was above where I had, I believe from an EPS perspective above where I was modeling out that you did not raise EBITDA guidance for the year. I’m just wondering that can of implies second half is a little bit on the lighter side, are there some dynamics there that are impacting that?

Mike Hagan

Lighter side from an EBITDA perspective?

Gregory Badishkanian - Citigroup

Well, because you've beat on the -- in Q1. So, I’m just wondering why didn’t you raise overall annual guidance, you’re just been conservative there or is it just the higher food cost, higher transportation cost, you are just trying to be conservative and --

Mike Hagan

I think we are just very cautious around food cost in particular and transportation.

Mike Hagan

It is not really related to marketing efficiency, Greg, its more related to what is happening in the gross margin line, and not sure, if we can pass along a price increase to the consumer in this economy.

Mike Hagan

I think its also important to point out, we do have a lot of development going on whether it is maintenance, or frozen -- we have a number of other initiatives internally to optimize revenue, and we just want to make sure that we have the capability to invest in those programs if we see they have traction. So we want to make sure we have the opportunity and a little bit more runway to get those programs in the market quicker on the investment side.

Gregory Badishkanian - Citigroup

Absolutely. In terms of just spending you initiated a dividend, just wondering what led you to that decision and I am assuming you feel very comfortable in terms of expanding internationally, maybe even making potential wellness-related acquisitions, you have enough cash on hand, enough cash flow, I am assuming you feel pretty comfortable with that?

Mike Hagan

Yeah, on the first question Greg, I think it’s speaks to the confidence the Board has in the business and the visibility that we have and in the cash flows to the business in the future years. I think it’s just a signal that there are a variety of ways we can return value to shareholders. Obviously, we were fairly aggressive on the buyback in Q1, but because we have a healthy balance sheet, i.e. no debt and we’ve got confidence in the cash flows over the next nine months we don’t have to really abort or change our behavior as it relate to the buyback and yet at the same time we can return value to shareholders via dividend. And we’re hoping to attract some stability in our shareholder base as result of that that would be an added benefit of that over the long-term

Gregory Badishkanian - Citigroup

Okay, good and just looking -- I mean obviously things really improved throughout the quarter and into April. So I guess would you attribute that to a little bit less spending by your competitors, as well as just your new marketing kind of kicking in and also just kind of focusing on different formats and if so what -- how would you kind of rank that in terms of what was the most important contributor to the improvement?

Mike Hagan

Well, I first say it's kind of all of the above. It’s tough to rank it. I would probably if I had to rank it I would say it was our launch of our new offers, and our new creative. I mean we clearly saw when three weeks started getting traction, we just start seeing conversion improve with a combination of the launch of that offer, at the same time when we were really nailing down our marketing efficiency in terms of going to the best outlets and got back into a good kind of momentum and then started investing as we saw that business come back. So if I had to rank them I’d say with those kind of two things, but I do believe as we’ve seen before that as that, very crowded spend in January and February started moderating and our spend stayed strong. It was reduced, but we were still out there with significant volume of advertising. Clearly the our- share-of-voice increased and when all those things came together that’s what really drove our improvement. It was really staying aggressive, begin more efficient on where we were putting our money and having a compelling new offer that actually converted those phone calls.

Gregory Badishkanian - Citigroup

Good work. Good to see the progress, thank you.

Operator

Your next question comes from Colin Sebastian - Lazard Capital Markets

Colin Sebastian – Lazard Capital Markets

Good afternoon and I’d like to add my congratulations to Joe and Mike as well. I guess first just wanted to follow-up on the last question on the marketing efficiency and the comments on competition maybe loosening up a little bit. Is that -- does that imply any change to the competitive landscape or was that just a function of spending from some of the other programs loosening up towards the end of the quarter and then as the follow-up on the FLEX program, I was curious if you have any data yet on the impact on the conversion rates specifically and if you're anticipating any cannibalization of orders from the full price program?

Mike Hagan

I think, what we typically see in the first quarter moving into Q2 is our competitors typically do bring their spend down. Obviously their advertising and marketing models are very, very different than ours. A lot of them are driving, I’m not even talking about our core commercial weight loss competitors, I’m talking about everyone in the category, and a lot of them are retail-driven type models. So we have the ability to stay out there pretty heavy for a long period of time because everything we are investing in is ROI based and as we continue to see improvement we continue to invest. So all of the customers we brought in, in first quarter despite sort of the two halves if you will, we’re profitable and as our profitability gap widened where we had more room we spent more money and we got very, very detailed in that approach. So I think this is a pretty predictable process for us and we track competitive spend and we understand the strategy behind the buys. We’re just in a different model in terms of being able to react on a day-to-day basis on the efficiency of our media.

Tom Connerty

And with respect to the day 5-Day Flex Program, I think there is a couple of things to keep in mind. First, like everything that we do around here and also that Joe mentioned in the -- in his portion of the presentation, we take very deliberate measured steps with everything that we do, not only from an advertising standpoint to understand the efficiency of the media buys that we make, but also the conversion that occurs on the web and on the call center with a new program introduction like this. And the program launch is in its early phases. We’re still measuring it and we are still determining whether there is cannibalization or to what degree cannibalization is occurring if any. I can tell you that the sales reps in the call center are very happy that they’ve got a lower price point offer to extend to customers who are much more value-conscious than they might have been a year ago. And then finally, the impact of the margin is actually slightly better on the 5-Day Flex Program than our 28-day program. So, I think in future calls we will be able to shed a little bit more light on it and give a better understanding of where we are with it?

Mike Hagan

Yeah, I’d add Colin that we are very sensitive to as Tom points out cannibalization. So the slow roll of this is really related to going to that what we think are the most incremental channels first. So if you’re thinking about customers we have had no response from for two years, or people that are canceling or saying that they are not buying because of the price. I mean, it is not something that we lead with in the call center, it is not something that is on the website and it’s being used as very targeted, very pro-active approach to those customers that we think we would actually get to actually sell down and so that is kind of position that we will keep with it. We don’t believe it will be something will be putting marketing dollars behind; you are not going to see Flex Program in mass media. It’s really going to be used as really a sell-down product for those people who are price sensitive.

Colin Sebastian – Lazard Capital Markets

Great. Thank you very much.

Operator

Your next question comes from William Sutherland - Boenning & Scattergood.

William Sutherland - Boenning & Scattergood Inc

On reactivation revenue -- I guess you said David it was nearly $40 million in the quarter?

David Clark

Yes.

William Sutherland - Boenning & Scattergood Inc

And that was certainly ahead of my model. I don’t know if -- is there a full-year expectation – the company had spoken to an expectation and react in the past for the fully year?

Mike Hagan

Yes we had mentioned in the full year guidance, when we came out in February, that it would be about 20% of revenues overall and I think that’s still a good number

William Sutherland - Boenning & Scattergood Inc

Even though it is a bit, just a hair better than that in the first quarter?

Mike Hagan

Yes, depending on how you seasonalize it yes,

Thomas Connerty

But it is fairly [inaudible] revenue stream throughout the year.

William Sutherland - Boenning & Scattergood Inc

Pretty steady as opposed to rising in the subsequent quarters?

Mike Hagan

Yes.

William Sutherland - Boenning & Scattergood Inc

Okay. Any comment or color on the women and men trends in the quarter year-to-date or whatever?

Michael Hagan

Let me just address that point about reactivations. We did give guidance for [a floor of] $140 million in our February call and if anything we feel more convinced that that is a low number. It’s still today, believe it or not one of the most misunderstood metrics in our business and obviously the way we define reactivation revenue, all of our customers are already in-house, meaning it is a nine month removed from the initial purchase. So they are all in-house and that sort of models and forecasts as tight as any metric and any trend in our business since -- so we’re more confident today just two months removed for making that statement and I think it bodes well for future quarters and future years beyond 2008.

William Sutherland - Boenning & Scattergood Inc

I mean if you just do the math Mike it should be nicely above $140.

Mike Hagan

I think David had mentioned it was $41 million in the quarter, and we obviously annualized that, it's ahead of where we are and I am not saying that that is something you can annualize but one thing that we got happier and happier about as the Q1 unfolded is the reactivation side of the business has been more or less insulated from the economic headwind that we see on the first time quarter accounts.

William Sutherland - Boenning & Scattergood Inc

And the new menu had to help, right?

Mike Hagan

Well I think the new menu, the new program I think that one of the things that hopefully didn’t get glossed over is the customer experience has been significantly improved. We’ve really turned that side of the business upside down in a more granular way than we’ve ever done it in the six years that I've been here. So I think that the orders were getting out of the warehouse on time. They were more accurate, certainly the better taste, the better exercise and behavior mod components in there, I think that all of that had a role in the retention rates as well as the reactivation rates of Q1.

Mike Hagan

Men versus women, it’s changed slightly; maybe men is just a touch below 30% of our business in Q1.

David Clark

That I would add, Bill that, we are seeing -- the strength that we really saw was in our core segment and that’s what we were really encouraged about, that the women’s program is where -- the true efficiency that we saw was really driven -- the seniors did well too. But to see our core business come back, that was a big driver of the improvements that we’ve seen have come mid February through kind of where we are today.

William Sutherland - Boenning & Scattergood Inc

Okay, you mentioned Canada; I kind of took away from the comments that’s at least on track with your goals for the year?

David Clark

Yes, that’s correct.

William Sutherland - Boenning & Scattergood Inc

And then last question on the expectation for marketing and revenue goes -- Joe or David mentioned low to mid 20% of revenue; is that for the balance of the year or is that kind of average for the full year?

Mike Hagan

Yes I think we will be back into the mid 20% range by the end of the year. We’ll be coming much back in line especially as we move into Q2 and Q3. From a percentage of revenue standpoint, we will be in the low 20s as we come into the second and third quarter. So it’s just a matter how that average kind of works out, but I think we are in pretty good shape to be in the low-to-mid 20% range by the end of the year.

William Sutherland - Boenning & Scattergood Inc

So – I’m seeing if I’m clear on that so, you mean for the nine months or just for the back quarter?

Mike Hagan

I mean for the full year. I think probably mid 20s will be sort of our full-years; because, I think we will be much more efficient as we get into the second and third quarter. We had 31% in the first, so to do the math you’ve got be in the low 20s to average in the mid-twenties right we’re kind of in the low 20s going into the second and third quarter and the fourth quarter.

William Sutherland - Boenning & Scattergood Inc

Got it and that just fits with all your program plans I guess?

Mike Hagan

Yes it does. I mean if we see even in, more efficiency, we will be upping our spend, but we will have the revenue to offset it.

William Sutherland - Boenning & Scattergood Inc

Got it. Okay. Thanks guys.

Operator

Your next question comes from Laura Richardson - BB&T Capital Markets

Laura Richardson - BB&T Capital Markets

Thanks. Just a couple of quick guidance questions, what should the share count be going into the third quarter?

David Clark

For the third quarter?

Laura Richardson - BB&T Capital Markets

I mean, the second quarter, excuse me.

David Clark

It is right at $31 million.

Laura Richardson - BB&T Capital Markets

Okay. And then for a Zero Water, should we continue to model that kind of equity loss for the rest of the year or at what point do you see that --?

Mike Hagan

I think, that would be the peak from an equity loss standpoint; that should start narrowing beginning in Q2.

Laura Richardson - BB&T Capital Markets

Could you be a little more specific in like when you might actually see that breaking even or being profitable?

Mike Hagan

It’s one of these deals Laura in when you find the marketing formula with direct consumer businesses once you get it one or two channels then you just scale it so it could happen literally  in a quarter. I don’t want to put two much pressure. We certainly didn’t expected it to be profitable when we made the investment six months back in Q1, so you need to be able to develop the product portfolio and start doing tests, and we are now in the test mode. We had some decent data points in Q1, but I think that will be a peak quarter from -- in terms of a loss in Q1. I can’t tell you how low it will get in Q2, and that’s one of the reasons why we looked at adjusted EBITDA as the best way to look at the health of the NutriSystem business.

Laura Richardson - BB&T Capital Markets

Yeah. Got it. Thanks. Okay and here is more fun question for you; when you are thinking ahead to 2009 and the new things on horizon and I heard you mentioned a maintenance, the frozen program again and U.K. Which you think could be the largest opportunity for you? I guess if you could rank then all in size?

Mike Hagan

The U.K. I think will be sort of entering that market again as Tom points out. We test and test before we put big spends in the market. So the U.K. impact on both top and bottom line would be rather small in 2009. I think the maintenance program I think could be, very impactful, but I think we’ll have a lot of learning from that from the end of the summer through the fourth quarter and I think we know our customer research said they’re asking for maintenance. They are absolutely asking us to provide a program that’s consistent with our science and our platform for them to keep this weight off and we’re very focused on that. And I think frozen could really be to sleeper in terms of length-of-stay, variety for our consumers. We know other competitors that have a frozen line, have a much longer length-of-stay and it give a much higher taste profile, more variety. We have to expand that product line. We’re starting with 14 some odd entrees as we test into that system. So they both kind of target two different things. I think maintenance extends our revenue opportunity with existing customers for an ongoing period and continued that relationship and I think frozen gives us the opportunity to drive real time revenue per customer in the initial cycle, because they potentially will increased their monthly rate as Mike mentioned earlier about allowing those consumers who are not price-sensitive to actually spend more money with us. Frozen gives us that opportunity and I also think it will have a direct impact on length-of-stay. So it’s a long winded way to say I think both maintenance and frozen together target two very different opportunities for us and I think both could be significant.

Laura Richardson - BB&T Capital Markets

Okay. If I had to try to answer my question which is going to be bigger based on what you just said I would say it sounds like maintenance. Is that fair?

Mike Hagan

I don’t know. I mean it’s too early to tell. I mean frozen I think is a very significant component. I would say they have equal chance of being -- of having impact on the business.

Laura Richardson - BB&T Capital Markets

Yeah. Okay. Thanks and good luck.

Operator

Your next question comes from Karen Howland - Lehman Brothers.

Karen Howland - Lehman Brothers

I was wondering if you could talk a little about your sales growth expectation for the second quarter. It seems like sales growth was down about 9% this quarter, but looking at the range of the guidance that you said it’s down closer to 11% to 15% in the second quarter. I was wondering why you actually expected it to be I guess worse than it was this quarter.

David Clark

Well, remember that both in this quarter and in the second quarter, we are dealing with two probably record quarters and increased [history] from ’07. So I think it’s appropriate for us to be a little bit conservative. In the second half of the year those comps become a little less dramatic. So I would say we are just being appropriately conservative around revenue.

Karen Howland - Lehman Brothers

There is nothing you’ve seen so far that would indicate that revenue is decreasing more in the second quarter than it was in the first?

Mike Hagan

Well, I think what we are doing in mid April was being appropriately cautious. We see what is going on out there in consumer discretionary kind of companies and we like what the trends are relative to marketing efficiency but having said that we want to be appropriately cautious when we’re looking at the next 2.5 months knowing that it was a very, very difficult quarter anniversary last Q2 of 2007.

Karen Howland - Lehman Brothers

Okay, it’s just looks like the quarter as far as the growth in the first quarter and second quarter of last year were both over that 61% to 62% and so I was just wondering if things were getting more but it’s sounds like a it’s just more cautious then anything else. Looking at the inventory levels, it appears that even excluding that $3 million of additional [Nourish] that you have inventory levels are up about 18% year-over-year. I was just wondering if there is any timing play there or any reason that would be.

Mike Hagan

No, we went into year-end with $82 million of inventory anticipating a much stronger January than we actually had as we said in the February call. So now we’re basically actively working that inventory down, through -- just through our sales process. So the Advance inventory should continue to work down throughout the course of the year.

Karen Howland - Lehman Brothers

Okay, great. And then kind of glossed over Japan a little bit during your prepared remarks, just as far as it being on schedule to your expectations. I know you previously said that you expected JV to begin to sale products in Japan I believe the beginning of 2009. I was wondering if you could give an update a little bit on, what the outlook is for that market -- expectation of when you expect to have more details on that.

Mike Hagan

Sure. I don’t think we ever said it was going to launch in the beginning of ’09, I think we’ve always said second half of ’09 for Japan. Japan is as you point out is a strategic partnership, it’s more the licensing agreement. We won’t be operating our NutriSystem business in Japan. We’re kind of exporting if you will our knowhow both on the marketing the product and the development. We are in kind of final stages of reaching agreement with a major partner in Japan. They’ve done a lot of pre-work on the market. They’ve invested quite a bit of time and resources on research and development on their own dime and we are expecting to get closer and closer on that in the next 30 days or so -- 30 to 45 days. Their plan is to start getting -- entering into the market in the latter half of 2009 as they move into test mode and trying to understand -- they are new to the market. It’s a great market for them and there is going to be a lot of test and learning going on. So the reason we kind of down played it a little bit is that it’s really not a business we’re operating, its more of a licensing agreement and strategic partnership.

Karen Howland - Lehman Brothers

Okay, great. Thanks for that additional color and one of the things I am having a little trouble getting my arms around. I recognize that you are trying to be more strategic with your marketing spend. I look at the marketing margin over the last several years though and it seems like it’s always at it’s lowest in the first quarter, just given the sales volume that you all have. How much comfort do you have that your going to be able to actually rein in that marketing expense in the second through fourth quarter giving the trends that have always existed that it seems to be a much higher on a margin basis?

Mike Hagan

Very comfortable. I mean I think when you look at prior year, I mean, there was -- clearly it was the same adjustment based on response and ROI and so we managed that. Pulling back marketing spend is not a difficult action for us to take. I mean all of our dollars are not committed. They are allocated based on response in ROI. We're already seen the efficiency, the improved efficiency as we started seeing it in March and we continue to see it in April. We feel pretty comfortable with it. I think if we have an opportunity, if we can actually continue to see improvement we may actually be, as I said earlier, actually be investing more. So the marketing spend management is really based on a profitability model and it's not very difficult for us to do that now. With saying that clearly there has been times in the company in the last year, where the strategic decisions that are made based on competitive situations and market dynamics. So, we will always look at that and try to make best decision for the long-term health of the business and the brand. So we don’t foresee anything like that happening that we don’t already see on the horizon. We think the economy is probably the biggest question mark for us going forward in terms of the ability for us to leverage our marketing dollars. But we don’t have any issues with marketing that spend to the point that I mentioned earlier.

Karen Howland - Lehman Brothers

And when you say you previously have always been focused on driving that more profitable dollar doesn’t the fact that the marketing margin has increased make that dollar less profitable?

Mike Hagan

I don’t follow.

Karen Howland - Lehman Brothers

You’ve said before that you have always been very focused on ROI which you clearly have a very strong on ROIC but as the marketing margin has increased if your look in 2006 or 2007 throughout the course of the year, presumably those dollars that you’re spending are less profitable then the dollars you are spending in the first quarter?

Mike Hagan

Well, you do get -- I mean clearly you get a higher demand in the first quarter. So your efficiency is typically if you take out competitive, environmental external factors, you should always be most efficient in your highest demand period. Clearly we didn’t see that in Q1. We had some obstacles in the first quarter that really drove us to change our philosophy and our tactics in our marketing spend and we did that primarily because we weren’t seeing the acquisitions. We weren’t seeing the conversions rates so we changed, but you are right. Typically what you would see in our business is first quarter is highest demand, second quarter is the next highest demand you, get into Q3 you have a couple of periods there of some strength and then Q4 is relatively weak. So that’s why our marketing spend typically declines because our opportunities related to demand also diminish.

Karen Howland - Lehman Brothers

Okay and then one other topic. I know you previously have discussed and I think this is a couple of quarters ago, the opportunities in health and wellness to make an acquisition and add that to your portfolio of products, is that still an initiative that you are looking actively for?

Mike Hagan

Not at this time.

Karen Howland - Lehman Brothers

Great, thank you so much.

Mike Hagan

We are still focused around our business right now.

Operator

Your final question comes from the Nicole Jacoby - Liberation Investment

Nicole Jacoby - Liberation Investment

I wanted to find out before you were saying that you were -- you continued to believe that about 20% of your ’08 revenue is going to be coming from the react and -- but then you it sounded as though maybe perhaps it might be more. In terms of the actual increase in your expectations from the last time I think of about $10 million, is that increase driven by increase in the react or is that, is it really driven equally by both parts of the business?

David Clark

You mean the increase in the revenue values?

Nicole Jacoby - Liberation Investment

Yes.

David Clark

Yeah. I would say it’s driven by confidence in the react business but also a better experience in terms of length-of-stay improving our revenue per customer.

Nicole Jacoby - Liberation Investment

Okay. And then the length-of-stay as applied to new customers react or both?

David Clark

Both.

Nicole Jacoby - Liberation Investment

Okay. So on a percentage basis you probably see slightly better from react -- more or slightly larger increase in react than versus your prior expectations if you average that out?

Mike Hagan

I think we are seeing -- yeah I think we are expecting more revenue from both reactivated customers and first time users.

Nicole Jacoby - Liberation Investment

Okay, great. And now have your expectations for the full-year ’08 for Canada changed since your last guidance?

Mike Hagan

No, I think it’s pretty consistent.

Nicole Jacoby - Liberation Investment

Okay. And in focusing a little bit, in looking at the react model that you used in order to, you said that you had fairly stable results there, has in the last quarter of experience has your model changed it all in how you are forecasting that in terms of experience?

Mike Hagan

No pretty -- very consistent.

Nicole Jacoby - Liberation Investment

Okay great. And then in terms of just generally what you have been -- all the things you’re focusing on you’ve gotten a bunch of new product development and new market development. Can you talk a little bit about how you’re making sure -- make sure that you’re maintaining focus on -- I mean it seems as though you’re maintaining focus on the business currently but how are you are going to maintain that going forward as you’re really developing all this new stuff?

Mike Hagan

Focus is clearly, critical [inaudible] but it’s really our core business. So you got to stay focused on the core business. We know how to kind of drive the marketing machine so extending into maintenance or frozen, is pretty kind of right down the strike zone of what we do every day. So we are not really stretching or reaching into a new category or a new product line or anything like that. Canada was relatively easy for us, very inexpensive for us to move across the boarder. Clearly U.K. gets a little bit harder but in some senses it’s actually easier because you got to set up a supply chain overseas and you got to get people over there to manage that in a vertical way, there’s not a lot integration with what happens here. One of the primary reasons we’re looking at the type of innovation we are looking at in terms of customer experience, frozen and maintenance is because it's our core business and the expertise we have and we’re just extending that into new offerings. So it really shouldn’t impact our focus for the business in '08.

Nicole Jacoby - Liberation Investment

Okay great. And the last question is about the more value oriented offerings that you are providing now. Clearly you are doing that by phone from your call center. What about people who are starting or going through the process to do online sign up, get to the page where put in their credit card and [fall off] are you providing any offers to them to -- value offers to them?

Thomas Connerty

Yes. We are providing but it is being done in a very contained campaign. We are targeting customers who we feel have been given enough opportunity to purchase the 28-day program, but haven’t done so at this point. So it is not as visible an offer to customers who are just coming onto the website for the first time. And as I mentioned before, we are going to do this in a step-by-step basis taking very measured risks and evaluating the information that we get back and then we will determine, how we roll this out.

Michael Hagen

Let me add to that, I mentioned our new e-commerce platform and one of the things we’re all very excited about as it provides you the opportunity to dynamically serve just those type of things that you are referring to, so imagine your scenario someone comes in; they actually come out at the price page. We literally with the new platform could dynamically serve a specific promotional offer that’s valid at that moment for that customer. So our sales funnel, the robust nature of how our real time impact and dynamic serving capability to all of these different deciles of customers who were coming to our website, expands dramatically with our new platform.

Nicole Jacoby - Liberation Investment

Okay great. Thank you guys very much.

Operator

There are no further questions. I would now like to turn the call back over to Mike Hagan for closing remarks

Michael Hagan

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

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