NutriSystem Corporation Q1 2008 Earnings Call Transcript

| About: Nutrisystem Inc (NTRI)

NutriSystem, Inc. (NASDAQ:NTRI)

Q1 2008 EarningsCall

April 23, 2008 5:00pm 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 - LiberationInvestment Group

Operator

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

David Clark

Good afternoon everyone andthank you for joining us to discuss NutriSystem’s first quarter 2008 financialresults. With us today from management are Michael Hagen, Chairman; JosephRedling, President and Chief Executive Officer-Elect; Thomas Connerty, ChiefMarketing Officer and Executive Vice President of Program Development; and I’m DavidClark, Chief Financial Officer.

Before we begin I’d like toremind everyone that this announcement contains forward-looking statements thatinvolve risks and uncertainties. Such information includes statements aboutNutriSystem’s first quarter financial results as well as statements that arepreceded by, followed by or include the words believes, plans, intends,expects, anticipates or similar expressions. Statements regarding NutriSystem’soutlook and guidance for the second quarter of 2008 and the full year 2008, itsexpectations regarding the affect of the economy on customer spending andsimilar statements that are not statements of historical constitute forward-lookingstatements. For such statements NutriSystem claims protection of the SafeHarbor for forward-looking statements contained in the Private SecuritiesLitigation Reform Act of 1995. Actual results may differ materially from theresults predicted and the reported results should not be considered as anindication of future performance.

Factors that could causeactual results to differ from those contained in the forward-looking statementsinclude but are not limited to those factors set forth in NutriSystem’s AnnualReport on Form 10-K for the year ended December 31, 2007 which has been filedwith the SEC. NutriSystem is making these statements as of April 23, 2008 andassumes no obligation to publically update or revise any of the forward-lookinginformation in this announcement.

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

Michael Hagen

Thank you David. Goodafternoon and thank you for joining us on today’s conference call. First I’d toreiterate the upcoming management transition we announced on April 8, 2008 andthen provide a few comments on 2008. Next Joseph Redling will provide you withour Q1 2008 results and update the progress on our growth initiatives. Then DavidClark 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. ThomasConnerty, our Chief Marketing Officer is here with us as well for Q&A.

As we had previouslyreleased effective May 1, 2008, Joseph Redling will succeed me as CEO and hewas elected to the Board of Directors effective April 7, 2008. On May 1, I willbecome the Non-Executive Chairman of the Board and remain an employee of thecompany. It has been a privilege to be the CEO of this company over these lastsix years. I’ve enjoyed every minute of it and I feel really quite proud ofwhat our team has accomplished. In a relatively short period of time we’vetaken 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 haveaffected the lives of more than 2.5 million people in this country in a healthyand positive way. Customer satisfaction comes from product efficacy andsuperior customer service and we have both here at NutriSystem. The enduringnature of our business will be our teams’ legacy and I couldn’t be morethrilled in turning the reins over to Joseph Redling, our company’s next ChiefExecutive Officer. I will continue to stay involved in the business and workwith Joe in the areas of strategy and business development.

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

In a move that takesadvantage of our strong cash position and healthy balance sheet, I am pleasedto 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 andwill be subject to determination by the Board of Directors each quarterfollowing its review of the company’s financial performance. David will go intomore details on that in a few minutes.

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

Joseph Redling

Thanks Mike. Let me alsotake this opportunity to say thank you Mike on behalf of myself, our managementteam and all NutriSystem employees. Your tremendous vision and leadership overthe last six years has resulted in the creation of a great business, a greatbrand and a solid foundation for growth. On a personal note, I truly value yoursupport, counsel and friendship and I look forward to building on ourrelationship in the years to come. Thanks again Mike.

Now let’s dive into firstquarter results, revenues came in at $216 million, down 9% versus a strong Q12007. Gross margin for the first quarter was 50.5% which represents a declineof close to 300 basis points compared to prior year, due primarily to increasedcost of food and transportation. Adjusted EBITDA was $26.6 million, down versusprior year reflecting the incremental marketing investment of $15.6 millionversus a year ago and the continued pressure on the gross margin line. Operatingincome came in at approximately $23.4 million.

After a tough start inJanuary, improved marketing efficiency later in the quarter along with improvedcustomer retention and stable reactivation revenue resulted in a first quarterthat was better than anticipated. Revenues were $216 million compared with our guidanceof $200 million to $210 million. There is no doubt that the weakening economyhas had an impact on our customers’ purchase decisions in the quarter. Wecontinued our tracking of economy-related obstacles with our potentialconsumers and saw our consumers continue to be influenced by their near term economicfears throughout Q1. However we did initiative programs to counter thesefactors that enabled us to improve our performance in the second half of Q1.

I will expand on this in amoment, but first let me address the gross margin challenge. As you have heardfrom many business sectors, price increases in food and transportation areimpacting gross margins. While we have been successful over the past few yearsleveraging our scale and holding costs in check, 2008 has proven to be a truechallenge. 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 andtransportation costs.

We are continuing to focuson this area and are working in partnership with our vendors to applycost-saving measures and to do the best we can to mitigate this challenge. Youwill recall that we did not implement a price increase at the beginning of thisyear as we continued to strive to provide value to the customer in thisdifficult economic climate. However we do plan on initiating price testinglater in the year to measure the feasibility of selected price increases toimprove our margins. We will also be monitoring our customer trends to be readyto act if we see stabilization in the economy where the environment for priceincreases may be more acceptable.

While we beat our adjustedEBITDA guidance for Q1 by more than 20%, this performance was negativelyimpacted by both our gross margin pressure as well as our decision in Januaryto continue to strategically invest early on in our marketing effort. Marketingspend as a percentage of revenue peaked at 31% for the quarter, as comparedwith 22% a year ago. This incremental spend of $15.6 million was initiated withtwo primary objectives in mind. The first was to maintain a strong competitiveshare-of-voice in the highest demand quarter in the year during what weanticipated to be a heightened competitive media environment.

Secondly it was ourintention to seed and support the launch of our new product; NutriSystemAdvance. Clearly category spending reached an all-time high in Q1. By ourestimates media spending for the entire category was the highest it has everbeen and this created a great deal of noise within the category. While thislevel of category spend did we believe create delays in purchase decisions, ourinvestment in media did result in continued increases and NutriSystem unaidedbrand awareness and consideration, that played a key role in stabilizing our performanceduring the latter half of the quarter.

As we entered February webegan 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 outin January, we did quickly respond and reallocate resources to our highestperforming channels and media outlets that began to immediately improve our overallmarketing efficiency. Looking forward marketing spend as a percentage ofrevenue will fall back in line with historical trends with full year spendingreturning to low to mid 20% range.

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

We continue to have threestrong core programs that appeal to a broad stratification of the weight lossmarket. In the first quarter of this year we have successfully launched new advertisingcampaigns to each segment. We are able to rollout our NutriSystem Silvercampaign featuring Tony Orlando. Tony lost more than 100 lbs. on the programand is an effusive cheerleader for NutriSystem. Additionally we launched a newcampaign featuring comedian featuring Larry The Cable Guy, touting our NutriSystemFor Men program. Also, Marie Osmond became the latest spokesperson for our corecustomer; women aged 35 to 55.

As previously discussedlike many other businesses, NutriSystem has felt the impact of the current economiccondition. We have been very proactive in not only how we manage our spend inthe challenging environment but how we innovate and address cost-drivenobjections. We were able to implement two important changes to our businesstowards the latter half of the quarter to connect with value-consciousconsumers.

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

Additionally we launched alower priced program for the customer to try called our 5-Day Flex Plan. The5-Day Flex Plan gives the customer a monthly program that consists of 20 daysof food and a meal planner for the remaining eight days that is priced $100less than our standard 28-day program. This allows us to give the customerprogram that is best suited for their current budget without sacrificing theirpotential for losing weight. Although we are in the early stages of testingthis plan we are very hopeful that it will help drive conversion of new customersand keep customers who are considering cancelling the program because of priceobjections, an opportunity to stick with NutriSystem.

We continue to be alearning organization that perpetually tests and we are continuing to evaluateadditional value-based creative and promotional programs that will enable us todeliver a strong value message across our many consumer-touch points. Throughdisciplined testing we obtain great information about our customers’ behaviorand we optimize that knowledge to improve business performance. Every decisionwe make regarding changes to media mix, product offering, creative executionand even pricing, is done step-by-step and by taking measured risks that giveus valid data that we can extrapolate from.

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

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

Now let’s talk about ourongoing relationship with QVC, NutriSystem sales on QVC experienced performancetrends similar to that of our direct business in the first quarter. Our Januaryperformance was disappointing but the performance showed healthy improvementover the second half of the quarter. The launch of the Advance program with QVCstarted in April. We had a very successful Advance introduction and actuallysold-out all of the available inventory during the anniversary programming onthe network earlier this month. Sales have been so robust on the network thatwe have been granted a second Today’s Special Value slated for July of thisyear. This is the third year in a row that we have granted a second airing of aTSV and it is a testament to the strength of our brand and the popularity andefficacy of our program.

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

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

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

Other key initiativesinclude the continued support and development of the NutriSystem Frozen line ofentrees and our new maintenance program that we expect will have a positiveimpact on both customer length of stay and revenue per customer. Both product initiativesare planned for test-rollout late summer of 2008.

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

In closing I’d to say Ibelieve we are in a good position to continue to deliver strong results in Q2and the second half of 2008. We have a very talented and focused managementteam and remain confident that our new initiatives, strong trends in revenueper customer and length of stay bode well for future growth in 2009 and beyond.

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

David Clark

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

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

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

The company has accrued fora 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 hadoccurred in the beginning of the quarter would have been $0.46. Non-cash stockcompensation had a $0.025 impact on EPS or the $1.4 million in total Imentioned earlier.

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

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

In the first quarter, werepurchased approximately $45 million of our own stock, which totaled 3.3million shares or almost 10% of the outstanding. A stock buyback authorizationof roughly $138 million remains in place, and we currently have approximately31 million shares issued.

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

This dividend returns a3.3% annualized dividend yield on a $21 share price, while allowing sufficientliquidity to opportunistically repurchase shares and most importantly having alarge portion of free cash available to make investments in growing our business.

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

Q2 revenues look to bebetween a $180 million and a $190 million and we expect EBITDA for the secondquarter to be $36 million to $40 million.

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

Thank you and I will nowturn it back over to Mike.

Michael Hagan

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

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

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

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

Question-and-AnswerSession

Operator

Your first question comesfrom Greg Badishkanian - Citigroup

GregoryBadishkanian - Citigroup

Congratulations Joe and reallynice work over the last several years in turning around the business Mike. Justa few questions here; first you mentioned that EBITDA guidance was basicallyunchanged although revenue guidance was increased, is that just due toincreasing food and transportation costs or is there anything else to that thatI’m missing?

David Clark

No, that’s primarily due tothe anticipated continued pressures from increasing food cost andtransportation.

GregoryBadishkanian - Citigroup

Okay.

Mike Hagan

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

Joseph Redling

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

GregoryBadishkanian - 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 viewingthat?

Mike Hagan

Yeah actually, the marginon the maintenance program is actually higher than our core program. So themaintenance program has very little hard costs to us versus our existinginventory. 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 changein the costs on the frozen line is really the shipping costs, which we’ll bepassing through to the consumer. So our goal is to maintain margins as we seeand of core shelf stable product with frozen and hopefully improve margins overtime as we see the maintenance program.

GregoryBadishkanian - Citigroup

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

Mike Hagan

Lighter side from an EBITDAperspective?

GregoryBadishkanian - Citigroup

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

Mike Hagan

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

Mike Hagan

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

Mike Hagan

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

GregoryBadishkanian - Citigroup

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

Mike Hagan

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

GregoryBadishkanian - Citigroup

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

Mike Hagan

Well, I first say it's kindof all of the above. It’s tough to rank it. I would probably if I had to rankit I would say it was our launch of our new offers, and our new creative. Imean we clearly saw when three weeks started getting traction, we just startseeing conversion improve with a combination of the launch of that offer, atthe same time when we were really nailing down our marketing efficiency interms of going to the best outlets and got back into a good kind of momentumand then started investing as we saw that business come back. So if I had torank them I’d say with those kind of two things, but I do believe as we’ve seenbefore that as that, very crowded spend in January and February startedmoderating and our spend stayed strong. It was reduced, but we were still outthere with significant volume of advertising. Clearly the our- share-of-voiceincreased and when all those things came together that’s what really drove ourimprovement. It was really staying aggressive, begin more efficient on where wewere putting our money and having a compelling new offer that actuallyconverted those phone calls.

GregoryBadishkanian - Citigroup

Good work. Good to see theprogress, thank you.

Operator

Your next question comesfrom Colin Sebastian - Lazard Capital Markets

Colin Sebastian –Lazard Capital Markets

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

Mike Hagan

I think, what we typicallysee in the first quarter moving into Q2 is our competitors typically do bringtheir 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 aboutour core commercial weight loss competitors, I’m talking about everyone in thecategory, and a lot of them are retail-driven type models. So we have theability to stay out there pretty heavy for a long period of time becauseeverything we are investing in is ROI based and as we continue to seeimprovement we continue to invest. So all of the customers we brought in, infirst quarter despite sort of the two halves if you will, we’re profitable andas our profitability gap widened where we had more room we spent more money andwe got very, very detailed in that approach. So I think this is a prettypredictable process for us and we track competitive spend and we understand thestrategy behind the buys. We’re just in a different model in terms of beingable to react on a day-to-day basis on theefficiency of our media.

Tom Connerty

And with respect to the day5-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 -- inhis portion of the presentation, we take very deliberate measured steps witheverything that we do, not only from an advertising standpoint to understandthe efficiency of the media buys that we make, but also the conversion thatoccurs on the web and on the call center with a new program introduction likethis. And the program launch is in its early phases. We’re still measuring it andwe are still determining whether there is cannibalization or to what degreecannibalization is occurring if any. I can tell you that the sales reps in thecall center are very happy that they’ve got a lower price point offer to extendto customers who are much more value-conscious than they might have been a yearago. And then finally, the impact of the margin is actually slightly better onthe 5-Day Flex Program than our 28-day program. So, I think in future calls wewill be able to shed a little bit more light on it and give a betterunderstanding of where we are with it?

Mike Hagan

Yeah, I’d add Colin that weare very sensitive to as Tom points out cannibalization. So the slow roll ofthis is really related to going to that what we think are the most incrementalchannels first. So if you’re thinking about customers we have had no responsefrom for two years, or people that are canceling or saying that they are notbuying because of the price. I mean, it is not something that we lead with inthe call center, it is not something that is on the website and it’s being usedas very targeted, very pro-active approach to those customers that we think wewould actually get to actually sell down and so that is kind of position thatwe will keep with it. We don’t believe it will be something will be puttingmarketing 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 whoare price sensitive.

Colin Sebastian –Lazard Capital Markets

Great. Thank you very much.

Operator

Your next question comesfrom 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 certainlyahead of my model. I don’t know if -- is there a full-year expectation – thecompany had spoken to an expectation and react in the past for the fully year?

Mike Hagan

Yes we had mentioned in thefull year guidance, when we came out in February, that it would be about 20% ofrevenues 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 youseasonalize it yes,

Thomas Connerty

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

William Sutherland- Boenning & Scattergood Inc

Pretty steady as opposed torising in the subsequent quarters?

Mike Hagan

Yes.

William Sutherland- Boenning & Scattergood Inc

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

Michael Hagan

Let me just address thatpoint about reactivations. We did give guidance for [a floor of] $140 millionin our February call and if anything we feel more convinced that that is a lownumber. It’s still today, believe it or not one of the most misunderstoodmetrics 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 removedfrom the initial purchase. So they are all in-house and that sort of models andforecasts as tight as any metric and any trend in our business since -- sowe’re more confident today just two months removed for making that statementand I think it bodes well for future quarters and future years beyond 2008.

William Sutherland- Boenning & Scattergood Inc

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

Mike Hagan

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

William Sutherland- Boenning & Scattergood Inc

And the new menu had tohelp, right?

Mike Hagan

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

Mike Hagan

Men versus women, it’schanged slightly; maybe men isjust a touch below 30% of our business in Q1.

David Clark

That I would add, Billthat, we are seeing -- the strength that we really saw was in our core segmentand that’s what we were really encouraged about, that the women’s program iswhere -- the true efficiency that we saw was really driven -- the seniors didwell too. But to see our core business come back, that was a big driver of theimprovements that we’ve seen have come mid February through kind of where weare 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 goalsfor the year?

David Clark

Yes, that’s correct.

William Sutherland- Boenning & Scattergood Inc

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

Mike Hagan

Yes I think we will be backinto the mid 20% range by the end of the year. We’ll be coming much back inline 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’sjust a matter how that average kind of works out, but I think we are in prettygood 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’mclear on that so, you mean for the nine months or just for the back quarter?

Mike Hagan

I mean for the full year. Ithink probably mid 20s will be sort of our full-years; because, I think we willbe 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 themid-twenties right we’re kind of in the low 20s going into the second and thirdquarter and the fourth quarter.

William Sutherland- Boenning & Scattergood Inc

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

Mike Hagan

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

William Sutherland- Boenning & Scattergood Inc

Got it. Okay. Thanks guys.

Operator

Your next question comesfrom Laura Richardson - BB&T Capital Markets

Laura Richardson -BB&T Capital Markets

Thanks. Just a couple ofquick guidance questions, what should the share count be going into the thirdquarter?

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 yearor at what point do you see that --?

Mike Hagan

I think, that would be thepeak from an equity loss standpoint; that should start narrowing beginning inQ2.

Laura Richardson -BB&T Capital Markets

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

Mike Hagan

It’s one of these dealsLaura in when you find the marketing formula with direct consumer businesses onceyou 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 twomuch pressure. We certainly didn’t expected it to be profitable when we made theinvestment six months back in Q1, so you need to be able to develop the productportfolio and start doing tests, and we are now in the test mode. We had some decentdata points in Q1, but I think that will be a peak quarter from -- in terms ofa loss in Q1. I can’t tell you how low it will get in Q2, and that’s one of thereasons why we looked at adjusted EBITDA as the best way to look at the healthof the NutriSystem business.

Laura Richardson -BB&T Capital Markets

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

Mike Hagan

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

Laura Richardson -BB&T Capital Markets

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

Mike Hagan

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

Laura Richardson -BB&T Capital Markets

Yeah. Okay. Thanks and goodluck.

Operator

Your next question comes fromKaren Howland - Lehman Brothers.

Karen Howland -Lehman Brothers

I was wondering if youcould 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 therange of the guidance that you said it’s down closer to 11% to 15% in thesecond quarter. I was wondering why you actually expected it to be I guessworse than it was this quarter.

David Clark

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

Karen Howland -Lehman Brothers

There is nothing you’veseen so far that would indicate that revenue is decreasing more in the secondquarter than it was in the first?

Mike Hagan

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

Karen Howland -Lehman Brothers

Okay, it’s just looks likethe quarter as far as the growth in the first quarter and second quarter oflast year were both over that 61% to 62% and so I was just wondering if thingswere getting more but it’s sounds like a it’s just more cautious then anythingelse. Looking at the inventory levels, it appears that even excluding that $3million 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 anyreason that would be.

Mike Hagan

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

Karen Howland -Lehman Brothers

Okay, great. And then kindof glossed over Japan a little bit during your prepared remarks, just as far asit being on schedule to your expectations. I know you previously said that youexpected 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 outlookis for that market -- expectation of when you expect to have more details on that.

Mike Hagan

Sure. I don’t think we eversaid it was going to launch in the beginning of ’09, I think we’ve always saidsecond half of ’09 for Japan. Japan is as you point out is a strategicpartnership, it’s more the licensing agreement. We won’t be operating ourNutriSystem business in Japan. We’re kind of exporting if you will our knowhowboth on the marketing the product and the development. We are in kind of finalstages of reaching agreement with a major partner in Japan. They’ve done a lot ofpre-work on the market. They’ve invested quite a bit of time and resources onresearch and development on their own dime and we are expecting to get closerand closer on that in the next 30 days or so -- 30 to 45 days. Their plan is tostart getting -- entering into the market in the latter half of 2009 as theymove into test mode and trying to understand -- they are new to the market. It’sa great market for them and there is going to be a lot of test and learninggoing on. So the reason we kind of down played it a little bit is that it’sreally not a business we’re operating, its more of a licensing agreement andstrategic partnership.

Karen Howland -Lehman Brothers

Okay, great. Thanks forthat additional color and one of the things I am having a little troublegetting my arms around. I recognize that you are trying to be more strategicwith your marketing spend. I look at the marketing margin over the last severalyears 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 havethat your going to be able to actually rein in that marketing expense in thesecond through fourth quarter giving the trends that have always existed thatit seems to be a much higher on a margin basis?

Mike Hagan

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

Karen Howland -Lehman Brothers

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

Mike Hagan

I don’t follow.

Karen Howland -Lehman Brothers

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

Mike Hagan

Well, you do get -- I meanclearly you get a higher demand in the first quarter. So your efficiency istypically if you take out competitive, environmental external factors, youshould always be most efficient in your highest demand period. Clearly wedidn’t see that in Q1. We had some obstacles in the first quarter that reallydrove us to change our philosophy and our tactics in our marketing spend and wedid that primarily because we weren’t seeing the acquisitions. We weren’tseeing the conversions rates so we changed, but you are right. Typically whatyou would see in our business is first quarter is highest demand, secondquarter is the next highest demand you, get into Q3 you have a couple ofperiods there of some strength and then Q4 is relatively weak. So that’s whyour marketing spend typically declines because our opportunities related todemand also diminish.

Karen Howland -Lehman Brothers

Okay and then one othertopic. I know you previously have discussed and I think this is a couple ofquarters ago, the opportunities in health and wellness to make an acquisitionand add that to your portfolio of products, is that still an initiative thatyou 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 aroundour business right now.

Operator

Your final question comesfrom the Nicole Jacoby - Liberation Investment

Nicole Jacoby -Liberation Investment

I wanted to find out beforeyou were saying that you were -- you continued to believe that about 20% ofyour ’08 revenue is going to be coming from the react and -- but then you itsounded as though maybe perhaps it might be more. In terms of the actualincrease 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 reallydriven equally by both parts of the business?

David Clark

You mean the increase inthe revenue values?

Nicole Jacoby -Liberation Investment

Yes.

David Clark

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

Nicole Jacoby -Liberation Investment

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

David Clark

Both.

Nicole Jacoby -Liberation Investment

Okay. So on a percentagebasis you probably see slightly better from react -- more or slightly largerincrease 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 andfirst time users.

Nicole Jacoby -Liberation Investment

Okay, great. And now haveyour expectations for the full-year ’08 for Canada changed since your lastguidance?

Mike Hagan

No, I think it’s prettyconsistent.

Nicole Jacoby -Liberation Investment

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

Mike Hagan

No pretty -- veryconsistent.

Nicole Jacoby -Liberation Investment

Okay great. And then interms of just generally what you have been -- all the things you’re focusing onyou’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’remaintaining focus on -- I mean it seems as though you’re maintaining focus onthe business currently but how are you are going to maintain that going forwardas 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 onthe core business. We know how to kind of drive the marketing machine so extendinginto maintenance or frozen, is pretty kind of right down the strike zone of whatwe do every day. So we are not really stretching or reaching into a newcategory or a new product line or anything like that. Canada was relativelyeasy 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 yougot to set up a supply chain overseas and you got to get people over there tomanage that in a vertical way, there’s not a lot integration with what happenshere. One of the primary reasons we’re looking at the type of innovation we arelooking at in terms of customer experience, frozen and maintenance is because it'sour core business and the expertise we have and we’re just extending that intonew offerings. So it really shouldn’t impact our focus for the business in '08.

Nicole Jacoby -Liberation Investment

Okay great. And the lastquestion 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 peoplewho are starting or going through the process to do online sign up, get to thepage where put in their credit card and [fall off] are you providing any offersto them to -- value offers to them?

Thomas Connerty

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

Michael Hagen

Let me add to that, Imentioned our new e-commerce platform and one of the things we’re all veryexcited about as it provides you the opportunity to dynamically serve justthose type of things that you are referring to, so imagine your scenariosomeone comes in; they actually come out at the price page. We literally withthe new platform could dynamically serve a specific promotional offer that’svalid at that moment for that customer. So our sales funnel, the robust natureof how our real time impact and dynamic serving capability to all of thesedifferent deciles of customers who were coming to our website, expandsdramatically with our new platform.

Nicole Jacoby -Liberation Investment

Okay great. Thank you guysvery much.

Operator

There are no furtherquestions. I would now like to turn the call back over to Mike Hagan forclosing remarks

Michael Hagan

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

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