Gorge On Nutrisystem's Yield

Summary

• In my view, this is an excellent entry price for Nutrisystem. The shares are down to a point where they are yielding just under 3.5%.
• In addition, covered calls offer an opportunity to enhance yield further.
• The market is forecasting a ridiculously pessimistic (and ahistorical) growth path here. I recommend taking advantage of the market's pessimism and buying.

The shares of Nutrisystem Inc. (NASDAQ:NTRI) are down about 46% over the past year, and that has me intrigued. I think the current price is a great entry point for long-term investors and I’ll go through my reasoning below by looking briefly at the business itself, and by focusing in on the financial history. I’ll model what I think is a reasonable future price based on the dividend, and I’ll suggest a way to enhance yield even further using covered call options. I’ll conclude with a discussion of the stock itself, as distinct from the business.

The crux of the argument is as follows: Although management is predicting softer revenue growth in 2018, the shares have already reacted to that news (down about 12% last month, down massively over the past twelve months). For that reason, I think all of the bad news is “baked in,” and investors buying today would be buying at a time when the risk of further capital loss is relatively low.

Background

Nutrisystem is a provider of weight loss solutions and weight management products and services. The company's program customers purchase monthly food packages, consisting of breakfasts, lunches, dinners and snacks and flex meal plan recipes. Nutrisystem offers more than 150 menu options at different price points and most of the customer's order on an auto-delivery, subscription type basis. The vast majority of sales (92%) are from online or over the telephone, the balance coming from retail sales.

In my view, Nutrisystem’s e-commerce, direct-to-consumer business model provides flexibility which allows the company to manage marketing expenses and react more dynamically to changes in customer demand. Although I like this model a great deal, there are two primary risks embedded in it in my view. Although the e-commerce, direct to consumer model is more flexible and less expensive than traditional retail, the key challenge for Nutrisystem is to keep advertising fresh and relevant. Related to this, the company needs to be highly adept at analyzing various advertising approaches, to determine which is most effective. At the moment, the company engages in a variety of advertising channels including television, radio, print, and social media. In my view, this is the main risk in the business here. That said, “main” risk is not the same thing as “significant” risk. The company seems to be quite good at managing all of this, as evidenced by the robust revenue growth over the past five years.

The second risk involves needing to access consumers directly. It’s challenging to convince new customers to buy food online or over the telephone. We like to have the opportunity to test products before we eat them. Thankfully for the company, their modest retail channel (representing only about 8% of sales) does allow customers to test various kits at various price points. My preference would be for the company to expand this channel somewhat.

New Programs Drive Revenue

In my opinion, the driver of growth here has been (and will eventually continue to be) the launch (in December 2016 and January 2017 respectively) of two new programs, the “Nutrisystem Lean13” and the “South Beach Diet.” These are “globally inspired”, flash frozen meals that (apparently) maintain taste and nutritional quality. I think these programs in particular will continue to drive revenue growth as the company uses them as a platform on which to build brand awareness with new customers and as a means to reactivate established customers.

Financial Snapshot

A quick review of the financial history here indicates that Nutrisystem is obviously a growth company. Revenue and net income have grown at a CAGR of 14%, and an eye watering 32% over the past five years. In spite of some dilution over that time, EPS is also up quite dramatically. Finally, net margin has quadrupled (from ~2% to just over 8%) over the past five years, which I consider to be a very good sign.

Nothing’s perfect, though, and Nutrisystem is no exception. In spite of having no debt and a massive cash hoard, the company had not raised its dividend per share in five years. , but they seem to have seen the light and have recently increased the dividend 43% from $.7 to $1. In addition, the company has been somewhat dilutive, having grown the share count at a CAGR of about 1.3% over the past five years. That said, like the recently announced dividend increase, they seem to have seen the light. Share count actually dropped somewhat (from 30.3 to 30.19 million) in the most recent quarter.

Source: Company filings, 10-K

Modeling The Dividend

Although the financial history here demonstrates that this is obviously a growth company, investors are understandably more interested in the future than the past. With that in mind, I must spend some time trying to forecast what may happen to shares over the next few years. Whenever I forecast, I engage in a ceteris paribus assumption, meaning that I hold all variables constant but the most important of them. I find this the most elegant approach to forecasting.

I think the dividend is critical to the buoyancy of the shares at these levels, so I’ll model it and hold all else (i.e. yield) constant.

Although it didn’t move for years, with the most recent dividend increase, the dividend has grown at a CAGR of about 7% over the past five years. Given the relatively low payout ratio, I consider this to be a reasonable growth expectation for the next four years. That said, I like to be as conservative in my forecasts as possible, so I’ll model a 5% growth rate for the dividend from now until 2022. I’m being conservative in this way because I like my surprises to be pleasant ones. When I model this growth assumption, while holding all else constant, I calculate a CAGR for the shares of about 8.2%. Also, fully 40% of my return expectation comes in the form of dividends, which are a far more predictable source of return, relative to expected capital gains.

Source: Author forecast

Covered Calls to Enhance Yield

For those interested in enhancing yield further, I think the June 2015 call option with a strike of 35 offers great value at these levels. The last price for these was $1.05, meaning that if an investor sold calls with a strike of $35, they could enhance the already generous yield by another 3.6%. I doubt the shares will rally between now and June, but if they do, shareholders will enjoy a 20% return when taken away. If, as is more likely in my view, the shares remain under $35 between now and the 3rd Friday of June, shareholders could simply resell calls at an appropriate strike to enhance yield further.

The Stock

Most investors access the future cash flows of a business via the public markets. The challenge, of course, is that stocks are sometimes (often) poor proxies for the health of the underlying firm. They swing much more wildly than is warranted by anything “fundamental.” The evidence seems to be that the market swings wildly between optimism and pessimism about a particular company. In my view, it’s particularly dangerous to buy when the market is optimistic, because the company must execute perfectly when the shares are priced for perfection. Anything less than that would result in a drop in share price. Thus, optimistically priced shares have a poor payoff profile in my opinion. If the company continues to execute well, the shares may not move much as perfection is already priced in. If, as is more typical in human activity, the company eventually missteps, the shares will plummet.

On the other hand, we might profit if the shares are priced pessimistically. In that circumstance, all of the bad news is “baked in” and the market will, eventually, reward good news with price appreciation. If you can make a decent yield on such a company, all the better in my view.

I use a host of measures to determine how optimistic or pessimistic the market is about a given name, but two that I write about on this forum involve looking at the market’s long term expectations about growth, and price to free cash flow per share. To unpack the former, I employ the method outlined by Professor Stephen Penman in his excellent book “Accounting for Value.” In this book, Penman uses a relatively standard finance formula (and some high school algebra) to isolate the “g” variable for a given stock. While this system isn’t a perfect predictor of what is going to happen obviously, it does offer some insight into what is over priced and what is underpriced. At the moment, the market is assuming a long term growth rate for this business of about 2.8%, which is unreasonably low and ahistorical in my view.

In regard to price to free cash, I like to see it trading on the lower end of the spectrum. As per the chart below, the price to free cash at Nutrisystem is clearly on the low end at the moment.

Source: Gurufocus

Conclusion

In my view, this is a growth company that’s currently trading as a deep value stock. I think the bad news is already more than priced in, and people who buy at these levels will enjoy a very decent return over the next five years. For those who want to generate even higher levels of yield, the covered call strategy outlined is also a good approach. In my view, price and value inevitably intersect, and I think investors would be wise to buy at this price before it rises to match the value per share.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NTRI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.