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Investors gagged on

NutriSystem

NutriSystem late Wednesday warned that it expected quarterly earnings of 62 cents to 66 cents a share, down from an earlier estimate of 77 to 82 cents a share and well below Wall Street's consensus forecast of 82 cents. The company put sales at $188 million, a 19% increase from a year ago but less than earlier guidance of $200 million to $208 million.

Based in Horsham, Pa., NutriSystem said it expected 218,000 new customers for its prepackaged dietary foods business in the third quarter, a 7% decline from last year and below an earlier estimate of 245,000.

"We continue to be satisfied with our success in reactivating former customers, but our performance with new customers we believe was affected by shorter-term competitive pressures which caused our marketing dollars to become less efficient, resulting in fewer new direct business customers than anticipated and customer acquisition costs to be higher than anticipated," Chairman and Chief Executive Michael Hagan said in the company's preannouncement.

The direct business, which ships dietary foods to customers, came under pressure from Alli, an over-the-counter diet pill sold by GlaxoSmithKline that came on the market in June. The drug blocks the absorption of fat and is taken at meal times. Alli is a form of Orlistat, Glaxo's prescription weight-loss aid.

The earnings warning generated a spate of downgrades to the stock. Analysts at Lazard Capital dropped NutriSystem to Hold from Buy, Broadpoint Capital cut it to Buy from Strong Buy, Canaccord Adams to Hold from Buy, and Kaufman Brothers to Hold from Buy.

The Analysis

NutriSystem bulked up quarter after quarter once it scrapped its diet centers and started marketing its meal plans to male customers, but the company seems to have underestimated the impact from Glaxo's new pill.

Nationally, there's plenty of demand for weight-loss products. About a third of American adults are obese, according to researchers at Emory University's Rollins School of Public Health in Atlanta, who on Tuesday published their findings online in the policy journal Health Affairs.

Analyst Bill Sutherland, at Philadelphia-area investment firm Boenning & Scattergood, says NutriSystem did very effective marketing using retired professional athletes such as the Miami Dolphins' Dan Marino and the Philadelphia Phillies' John Kruk. The latter, a portly ex-baseball player, cheerfully proclaimed that his wife told him "since I've started losing weight on NutriSystem, I'm not as disgusting as I used to be, and that I'm not half-bad looking anymore."

When Alli hit the shelves in June, NutriSystem seemed ready, Sutherland says.

"Based on the company's commentary when they reported in the second quarter, it seemed that they had calibrated things pretty carefully for Alli's arrival," he says. "They'd seen it hit the market, they'd seen it have some impact and they also believed that impact would lessen over time after the initial marketing effort."

Nope.

"Clearly, we had underappreciated the competitive impact of Alli, whose target market coincides significantly with that of NTRI," Kaufman analyst Sameet Sinha wrote Thursday. "Since new customer acquisition is an integral part of NTRI's business model, we feel the impact from Alli will continue to take its toll on the company. While it was once easy to acquire customers, it may become increasingly difficult to do so now."

Sutherland says Chief Financial Officer James Brown's estimated customer acquisition costs of $212 to $216 are a 50% increase from a year ago and were a major factor in investors' negative reaction. However, higher costs also reflect "brutal" comparisons from a year ago, when the Marino campaign was fueling remarkable new business growth.

The falloff alarmed Canaccord analyst Scott Van Winkle, who wrote Thursday that NutriSystem's "business model appears to be broken" in a report titled "Throwing in the Towel."

"Given that Q3 faced a tough comparison and the launch of the weight-loss pill Alli, we expected Q3 would be a modest quarter of earnings growth with no upside," he wrote. "However, business appears to have decelerated throughout the quarter, validating the success of Alli, which we did not believe would be sustained. Indications that the company is more aggressive in making acquisitions outside of weight loss indicate that growth has come to a halt in the core business, in our opinion."

Brown, the CFO, alluded to the takeover strategy Wednesday, saying there was $600,000 in transaction costs "associated with a proposed acquisition the company is no longer pursuing."

The Bottom Line

NutriSystem successfully shifted its business once before, and its $10-a-day meal plans fit more completely into customers' weight-loss and food budgets than Alli, which costs about $60 for a one month starter pack on top of regular food costs. But it's seeing a diminished return on its marketing spending, warns Thomas Weisel Partners analyst Jim Duffy, and that cuts the Street's ability to weigh in on its future prospects.

"While the stock looks cheap after the aftermarket pullback, we believe it is difficult to forecast 2008 in light of the Alli threat," Kaufman's Sinha wrote. "We believe, for the first time, the likelihood of negative growth in 2008 is a possibility. We have significantly reduced our estimates and acknowledge our inability to forecast this business in light of the competitive threat from Alli, prompting our Hold rating."

Sutherland says plans for a new mix of products, including some frozen foods, and strong customer retention rates, are good signs, but other analysts see trouble ahead.

"Given that the competitive pressures appear to have intensified throughout the quarter, it isn't prudent to assume anything but continued pressure into the Q1 diet season," Van Winkle wrote. "As a result, all of the catalysts expected to drive the shares higher, such as a renewed diet plan in Q1, a more favorable marketing environment than last year and a relatively modest valuation, are negated by the weaker results expected."

Additionally, he sees the acquisition attempts as a sign that NutriSystem's weight-loss business has peaked, and that the company's move to fitness and wellness products offers little promise of further market penetration.

Sutherland thinks there may be some overselling on Thursday, but doesn't expect shares to balloon back for a few months.

"Until we get to end of year there won't be any meaningful information for the market to digest," he says.

If Americans could lose weight as fast as NutriSystem's shares lost value, our obesity epidemic would go, well, the way of all flesh.