NutriSystem (NTRI, Financial) is in a very interesting business. Typically through NTRI’s Core Auto-Delivery program, customers purchase monthly food packaged containing a 28-day supply of breakfasts, lunches, dinners and deserts, which they supplement with dairy, fruit, salad, vegetables and low-glycemic carbohydrate items. The program is regularly priced between $300 and $330 per shipment, or about $11 to $12 per day (today the price is lower than normal at around $250).
From a customer’s perspective, NTRI provides a convenient and very easy, effective way to lose weight. Customers usually stay on the program for 10 to 11 weeks and lose on average 1 to 2 pounds per week. A lot of customers lose 40 pounds per month. Essentially, NTRI is the perfect choice for overweight people who are busy and prefer convenient diets, and are not too demanding of food taste.
Competition
1. Weight Watcher
Weight Watcher (WTW) is the biggest weight-management company. WTW does compete with NTRI, but these two companies target two different market segments. WTW is for people who are really committed and seek to change their eating habits. So, can WTW steal customers from NTRI with a low price or vice versa?
WTW will not steal customers from NTRI. NTRI customers want the convenience of packaged meals; they will not switch to WTW no matter how cheap WTW is. Actually the prices are not comparable because of the difference in business model. I watched NTRI’s ads, talked to salespeople and NTRI’s customers, and all left me the impression of the convenience and efficacy of NTRI’s products. Only those who failed with NTRI, because they cheated, might want to go to WTW for continual pressure and encouragement. The other way around is more likely. WTW tries to engender behavior modification so their members must be extremely disciplined and committed in order to succeed. I suspect a lot of WTW’s customers cannot self-control and end up using NTRI. Some of NTRI’s customers I talked to fall into this group.
For those successful with WTW, my guess was that they will stop using WTW after getting into healthy eating habits. Interestingly, WTW has a lot of loyal members. One member even says “he attends meetings religiously, sticks to plan religiously and journal religiously”. Perhaps attending meetings to share experience, challenges or to get motivated, has become their habit; even this is not free.
In summary, these two companies aim at different people. NTRI offers a very effective system with a lot of appeal to people. WTW does not use such an appealing system, but those who are successful with WTW become truly fanatical about WTW.
2. Other packaged-diet competitors
There are three important points in understanding how well NTRI perform against competition.
First, NTRI is the best company in this segment. They have the top-rated diet program, and the price is among the lowest in the market.
Second, NTRI receive great reviews from customers. Ninety percent of customers state that they will recommend NTRI to family and friends. And NTRI continues to invest in product development to enhance food taste while avoiding the normal pitfalls of low-calorie dieting approaches like hunger or cravings.
Third, this business is really built around advertising, on which NTRI spends about $150 million compared to $257 million sales of their closest competitor Medifast (MED). This is where NTRI enjoys advantage. NTRI is the biggest company in this segment, which gives them scale advantage in marketing because their ads not only get new customers but also reactivate former customers.
Consider that a new player spends $X in marketing to get $Y in sales. For the same marketing expense, NTRI, with their brand awareness, can easily match the entrant’s marketing efficiency and will not get $Y but Y*4/3 dollars in sales because reactivation revenue comprises 25% of total sales (and reactivation revenue will play bigger role as NTRI acquire more customers.) Because advertising expense is 29% of sales (in a normal macro environment, advertising as percentage of sales would be lower,) X/(Y*4/3) = 29% so X/Y = 38.5%. So, NTRI enjoys marketing scales advantage. That advantage is not great because NTRI does not have repeat customers like other consumer product companies, but it is still good.
Word-of-mouth recommendation, though hard to quantify, is also an important source of competitive advantage. Therefore, new players, without word-of-mouth referral and brand recognition, are at a big competitive disadvantage, and, to a lesser extent, so are smaller incumbent competitors. NTRI will widen their moat with each new customer they acquire.
Spending $300 on a monthly basis is really a big-ticket item. Customers may do a lot of research and comparisons when choosing a diet program. Actually all diet programs are effective but psychological issue plays an important role. That turns NTRI’s reviews, worth-of-mouth referrals, and brand awareness into their competitive advantage. NTRI may not enjoy premium price because they should keep their price competitive to maintain and gain market share, which then widens their moat, but they will still get a higher than average profit margin thanks to their scales advantage.
3. Medifast (MED)
MED is an interesting company to look at. They have a different business model. They are a direct marketing company. About 2/3 of their sales comes from Take Shape for Life program. Basically, they have a coaching network, which consists of independent contractor health coaches who are trained to coach and support clients on Medifast weight loss programs. Most health coaches are recruited by existing health coach and most new health coaches started as a client of a health coach. MED pays about 20% commission to their health coaches. In current market environment, 20% is lower than NTRI’s marketing expense as percentage of sales but that would be higher in a normal condition. I see the commission fees as money MED pays their customers to buy their referrals. NTRI can gain free words-of-mouth recommendations but their customers surely do not have the incentive like that of MED’s health coaches.
So, NTRI uses multimedia marketing to target a broad market while MED creates a viral growth out of their customers. Which model is better? I think NTRI’s model is quicker to create brand awareness and can get more dollar sales for each marketing dollar they spend in a normal condition. However, NTRI sales slumped since 2008 while MED sales grew impressively. I think it is because MED’s model is much more effective to get new customers in current kind of environment. Spending on weight loss program is discretionary and NTRI marketing and pricing promotion really just got their former customers as Mr. CEO Joseph Redling said in recent conference call: “People that – a lot of our customers right now that we’re generating orders from are people that have been with us before. They’re waiting for a good deal. We’re not – we don’t have a lot of opportunity right now to attract that new customer to Nutrisystem because we don’t have the compelling new news to get them to reconsider us or to consider us for the first time.” Meanwhile, MED has active, aggressive health coaches selling their products. The longer the current condition lasts, the more market share MED gets. However, the weight management market is huge and both NTRI and MED can be winners. Moreover, as MED brings more customers to commercial weigh loss programs, those new customers might someday look for good deal and consider NTRI, a great brand.
Capital Allocation
NTRI’s business model does not require much investment. They outsource production to third party manufacturers so they only need to retain cash for product development, inventory and marketing. That allows them to earn extremely high return on equity. NTRI’s 5-year average pretax ROE is 79%. Therefore, capital allocation would be the decisive factor in whether to invest in NTRI.
I think the managements are doing a good job at capital allocation. They pay generous dividend and buy back a lot of stock (totaled about $362 million since 2006.) Impressively, NTRI built up cash balance in 2009 because of economic uncertainty but in 2010, they repurchased $75million shares, $20 million of which was financed by low interest rate debt at 2%. They did not repurchase stocks (but are still paying generous dividend) this year because they are preparing for their new programs:
“You know we are opportunistic around share repurchases, but a lot goes into it in terms of what we’re looking at from an inventory build; what we’re looking at in terms of expenses in the quarter. So look, the last time we had a $300 million share repurchase authorization, we spent $244 million over a two plus year period. And that’s the reason we authorized another $150 million. The Board and management are committed to returning cash to shareholders. We’ve got a $20 million dividend payout every year, and we’ll use share repurchase as we see fit.”
“So, the way we think about – if you think about our Direct business being related more toward an accelerated structured weight loss position. You’re eating every meal. It’s all about weight loss. It’s effective weight loss. It’s very restrictive. It’s 28 days. That’s a segment that we’re serving today.
We think retail is much more along the lines of flexible weight management, to give people the opportunity to choose products on an individual one item basis to fit into their own lifestyles for weight management. Not necessarily eating five of our products every day to lose weight, but actually competing in the aisle for share of wallet for people that are just looking for better, healthy choices on healthy snacking and specific meal occasions. So, we do think it’s complementary.”
“So, we feel that the category, new matters in the category; always has, always will. We think spokespeople really matter as well to get people to consider the product. And as long as your innovation in your new product is real, that it’s not just a marketing spiff, it’s real product innovation, which we believe we have, I think you have the opportunity to really impact your demand flow.” – [url=http://seekingalpha.com/article/304736-nutrisystem-s-ceo-discusses-q3-2011-results-earnings-call-transcript?part=qanda]2011
Q3 Earning Call[/url]
Margin of Safety
I think the best way to assess margin of safety is to estimate a conservative return I can get from a company if I hold the company forever. The problem with NTRI is customer disloyalty. Customers stay on the program until they achieve their target weight, usually 10-11 weeks, although they might go back in the future. NTRI is no Geico. Geico can spend a lot in advertising to get a customer because car insurance has very low churn. This is not the case for NTRI. Therefore, in this business, I am more concerned about the cost to acquire a new customer, and the number of customers NTRI needs to serve each year to make an adequate return.
Advertising expense is variable because NTRI need to increase marketing spending to get more customer. G&A is largely variable because most people who work at NTRI are in the call center and call center staffing is, of course, based on customer demand. In 2010, NTRI had 13% of sales to cover D&A, and tax expense. In a normal condition, NTRI can get more cents for each dollar sales so 13% is conservative. D&A are generally fixed. I want a 15% return on my investment (you might want a different hurdle rate.) Giving no value to their $42 million net cash, at the current market cap of $317 million (or $11.34 share price) and at 35% tax rate, NTRI must achieve $668 million revenue. Assuming each customer pays a normal price of $300 per month and stay for 10 weeks, $668 million sales translate into about 890,000 customers per year. Is this achievable?
NTRI is like a timber harvester in a sense that they exploit the timberland but if there is no stable supply of new trees, they will have no business in the future. In this case, some of the trees they cut off will grow back and be ready to be harvested. There will also be new natural trees. However, NTRI does not control the supply. NTRI is a passive harvester.
According to NTRI’s latest investor presentation, there are about 96 million dieters in the US. Approximately 8% of them participated in commercial weight loss programs and 56% conducted some form of self-directed diet. Based on these numbers, 4.48 million people are using commercial weight loss programs, and 53.8 million people are conducting self-directed diet. It takes 6 months to 3 years or whatever for those who lose weight to gain back. There are also a lot of people going to get the “overweight status”. So, I think it is safe to assume that NTRI can get 890,000 customers every year. They achieved $777 million sales in 2007, and they now have larger former customer base, which give higher reactivation opportunity.
It is very dangerous to value a stock based on earning. Geico offers margin of safety because we can safely expect existing customers to stay with them. NTRI does not give that kind of margin of safety. However, I still see margin of safety in NTRI because they just need to capture a small portion of market to make an adequate return. NTRI is the best packaged diet company and has marketing advantages. The products receive very good reviews and are already among the cheapest in the market. NTRI is in a better position than anyone else to capture any potential customers. Weak consumer confidence can continue and MED can get market share but NTRI’s strong balance sheet and their flexible cost structure allow them to stay in the business. The weight management market is massive and I think NTRI’s long-term outlook is favorable. I think NTRI can give 15% return at current price and I trust the company’s capital allocation.
Final words: I deliberately limited using numbers in this analysis. I just want to analyze the business, which I think is good, but not great, and to share my opinion on margin of safety, which I believe is adequate. I think my analysis provides a helpful guide. Readers should read the company’s 10-Ks, do their own spreadsheets, read earning call transcripts, check the products, and talk to customers and sales people to make their own decision.
From a customer’s perspective, NTRI provides a convenient and very easy, effective way to lose weight. Customers usually stay on the program for 10 to 11 weeks and lose on average 1 to 2 pounds per week. A lot of customers lose 40 pounds per month. Essentially, NTRI is the perfect choice for overweight people who are busy and prefer convenient diets, and are not too demanding of food taste.
Competition
1. Weight Watcher
Weight Watcher (WTW) is the biggest weight-management company. WTW does compete with NTRI, but these two companies target two different market segments. WTW is for people who are really committed and seek to change their eating habits. So, can WTW steal customers from NTRI with a low price or vice versa?
WTW will not steal customers from NTRI. NTRI customers want the convenience of packaged meals; they will not switch to WTW no matter how cheap WTW is. Actually the prices are not comparable because of the difference in business model. I watched NTRI’s ads, talked to salespeople and NTRI’s customers, and all left me the impression of the convenience and efficacy of NTRI’s products. Only those who failed with NTRI, because they cheated, might want to go to WTW for continual pressure and encouragement. The other way around is more likely. WTW tries to engender behavior modification so their members must be extremely disciplined and committed in order to succeed. I suspect a lot of WTW’s customers cannot self-control and end up using NTRI. Some of NTRI’s customers I talked to fall into this group.
For those successful with WTW, my guess was that they will stop using WTW after getting into healthy eating habits. Interestingly, WTW has a lot of loyal members. One member even says “he attends meetings religiously, sticks to plan religiously and journal religiously”. Perhaps attending meetings to share experience, challenges or to get motivated, has become their habit; even this is not free.
In summary, these two companies aim at different people. NTRI offers a very effective system with a lot of appeal to people. WTW does not use such an appealing system, but those who are successful with WTW become truly fanatical about WTW.
2. Other packaged-diet competitors
There are three important points in understanding how well NTRI perform against competition.
First, NTRI is the best company in this segment. They have the top-rated diet program, and the price is among the lowest in the market.
Second, NTRI receive great reviews from customers. Ninety percent of customers state that they will recommend NTRI to family and friends. And NTRI continues to invest in product development to enhance food taste while avoiding the normal pitfalls of low-calorie dieting approaches like hunger or cravings.
Third, this business is really built around advertising, on which NTRI spends about $150 million compared to $257 million sales of their closest competitor Medifast (MED). This is where NTRI enjoys advantage. NTRI is the biggest company in this segment, which gives them scale advantage in marketing because their ads not only get new customers but also reactivate former customers.
Consider that a new player spends $X in marketing to get $Y in sales. For the same marketing expense, NTRI, with their brand awareness, can easily match the entrant’s marketing efficiency and will not get $Y but Y*4/3 dollars in sales because reactivation revenue comprises 25% of total sales (and reactivation revenue will play bigger role as NTRI acquire more customers.) Because advertising expense is 29% of sales (in a normal macro environment, advertising as percentage of sales would be lower,) X/(Y*4/3) = 29% so X/Y = 38.5%. So, NTRI enjoys marketing scales advantage. That advantage is not great because NTRI does not have repeat customers like other consumer product companies, but it is still good.
Word-of-mouth recommendation, though hard to quantify, is also an important source of competitive advantage. Therefore, new players, without word-of-mouth referral and brand recognition, are at a big competitive disadvantage, and, to a lesser extent, so are smaller incumbent competitors. NTRI will widen their moat with each new customer they acquire.
Spending $300 on a monthly basis is really a big-ticket item. Customers may do a lot of research and comparisons when choosing a diet program. Actually all diet programs are effective but psychological issue plays an important role. That turns NTRI’s reviews, worth-of-mouth referrals, and brand awareness into their competitive advantage. NTRI may not enjoy premium price because they should keep their price competitive to maintain and gain market share, which then widens their moat, but they will still get a higher than average profit margin thanks to their scales advantage.
3. Medifast (MED)
MED is an interesting company to look at. They have a different business model. They are a direct marketing company. About 2/3 of their sales comes from Take Shape for Life program. Basically, they have a coaching network, which consists of independent contractor health coaches who are trained to coach and support clients on Medifast weight loss programs. Most health coaches are recruited by existing health coach and most new health coaches started as a client of a health coach. MED pays about 20% commission to their health coaches. In current market environment, 20% is lower than NTRI’s marketing expense as percentage of sales but that would be higher in a normal condition. I see the commission fees as money MED pays their customers to buy their referrals. NTRI can gain free words-of-mouth recommendations but their customers surely do not have the incentive like that of MED’s health coaches.
So, NTRI uses multimedia marketing to target a broad market while MED creates a viral growth out of their customers. Which model is better? I think NTRI’s model is quicker to create brand awareness and can get more dollar sales for each marketing dollar they spend in a normal condition. However, NTRI sales slumped since 2008 while MED sales grew impressively. I think it is because MED’s model is much more effective to get new customers in current kind of environment. Spending on weight loss program is discretionary and NTRI marketing and pricing promotion really just got their former customers as Mr. CEO Joseph Redling said in recent conference call: “People that – a lot of our customers right now that we’re generating orders from are people that have been with us before. They’re waiting for a good deal. We’re not – we don’t have a lot of opportunity right now to attract that new customer to Nutrisystem because we don’t have the compelling new news to get them to reconsider us or to consider us for the first time.” Meanwhile, MED has active, aggressive health coaches selling their products. The longer the current condition lasts, the more market share MED gets. However, the weight management market is huge and both NTRI and MED can be winners. Moreover, as MED brings more customers to commercial weigh loss programs, those new customers might someday look for good deal and consider NTRI, a great brand.
Capital Allocation
NTRI’s business model does not require much investment. They outsource production to third party manufacturers so they only need to retain cash for product development, inventory and marketing. That allows them to earn extremely high return on equity. NTRI’s 5-year average pretax ROE is 79%. Therefore, capital allocation would be the decisive factor in whether to invest in NTRI.
I think the managements are doing a good job at capital allocation. They pay generous dividend and buy back a lot of stock (totaled about $362 million since 2006.) Impressively, NTRI built up cash balance in 2009 because of economic uncertainty but in 2010, they repurchased $75million shares, $20 million of which was financed by low interest rate debt at 2%. They did not repurchase stocks (but are still paying generous dividend) this year because they are preparing for their new programs:
“You know we are opportunistic around share repurchases, but a lot goes into it in terms of what we’re looking at from an inventory build; what we’re looking at in terms of expenses in the quarter. So look, the last time we had a $300 million share repurchase authorization, we spent $244 million over a two plus year period. And that’s the reason we authorized another $150 million. The Board and management are committed to returning cash to shareholders. We’ve got a $20 million dividend payout every year, and we’ll use share repurchase as we see fit.”
“So, the way we think about – if you think about our Direct business being related more toward an accelerated structured weight loss position. You’re eating every meal. It’s all about weight loss. It’s effective weight loss. It’s very restrictive. It’s 28 days. That’s a segment that we’re serving today.
We think retail is much more along the lines of flexible weight management, to give people the opportunity to choose products on an individual one item basis to fit into their own lifestyles for weight management. Not necessarily eating five of our products every day to lose weight, but actually competing in the aisle for share of wallet for people that are just looking for better, healthy choices on healthy snacking and specific meal occasions. So, we do think it’s complementary.”
“So, we feel that the category, new matters in the category; always has, always will. We think spokespeople really matter as well to get people to consider the product. And as long as your innovation in your new product is real, that it’s not just a marketing spiff, it’s real product innovation, which we believe we have, I think you have the opportunity to really impact your demand flow.” – [url=http://seekingalpha.com/article/304736-nutrisystem-s-ceo-discusses-q3-2011-results-earnings-call-transcript?part=qanda]2011
Q3 Earning Call[/url]
Margin of Safety
I think the best way to assess margin of safety is to estimate a conservative return I can get from a company if I hold the company forever. The problem with NTRI is customer disloyalty. Customers stay on the program until they achieve their target weight, usually 10-11 weeks, although they might go back in the future. NTRI is no Geico. Geico can spend a lot in advertising to get a customer because car insurance has very low churn. This is not the case for NTRI. Therefore, in this business, I am more concerned about the cost to acquire a new customer, and the number of customers NTRI needs to serve each year to make an adequate return.
Advertising expense is variable because NTRI need to increase marketing spending to get more customer. G&A is largely variable because most people who work at NTRI are in the call center and call center staffing is, of course, based on customer demand. In 2010, NTRI had 13% of sales to cover D&A, and tax expense. In a normal condition, NTRI can get more cents for each dollar sales so 13% is conservative. D&A are generally fixed. I want a 15% return on my investment (you might want a different hurdle rate.) Giving no value to their $42 million net cash, at the current market cap of $317 million (or $11.34 share price) and at 35% tax rate, NTRI must achieve $668 million revenue. Assuming each customer pays a normal price of $300 per month and stay for 10 weeks, $668 million sales translate into about 890,000 customers per year. Is this achievable?
NTRI is like a timber harvester in a sense that they exploit the timberland but if there is no stable supply of new trees, they will have no business in the future. In this case, some of the trees they cut off will grow back and be ready to be harvested. There will also be new natural trees. However, NTRI does not control the supply. NTRI is a passive harvester.
According to NTRI’s latest investor presentation, there are about 96 million dieters in the US. Approximately 8% of them participated in commercial weight loss programs and 56% conducted some form of self-directed diet. Based on these numbers, 4.48 million people are using commercial weight loss programs, and 53.8 million people are conducting self-directed diet. It takes 6 months to 3 years or whatever for those who lose weight to gain back. There are also a lot of people going to get the “overweight status”. So, I think it is safe to assume that NTRI can get 890,000 customers every year. They achieved $777 million sales in 2007, and they now have larger former customer base, which give higher reactivation opportunity.
It is very dangerous to value a stock based on earning. Geico offers margin of safety because we can safely expect existing customers to stay with them. NTRI does not give that kind of margin of safety. However, I still see margin of safety in NTRI because they just need to capture a small portion of market to make an adequate return. NTRI is the best packaged diet company and has marketing advantages. The products receive very good reviews and are already among the cheapest in the market. NTRI is in a better position than anyone else to capture any potential customers. Weak consumer confidence can continue and MED can get market share but NTRI’s strong balance sheet and their flexible cost structure allow them to stay in the business. The weight management market is massive and I think NTRI’s long-term outlook is favorable. I think NTRI can give 15% return at current price and I trust the company’s capital allocation.
Final words: I deliberately limited using numbers in this analysis. I just want to analyze the business, which I think is good, but not great, and to share my opinion on margin of safety, which I believe is adequate. I think my analysis provides a helpful guide. Readers should read the company’s 10-Ks, do their own spreadsheets, read earning call transcripts, check the products, and talk to customers and sales people to make their own decision.
