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Article by DailyStocks_admin    (05-26-08 07:21 AM)

The Daily Magic Formula Stock for 05/26/2008 is NutriSystem Inc. According to the Magic Formula Investing Web Site, the ebit yield is 35% and the EBIT ROIC is >100 %.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


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BUSINESS OVERVIEW

Overview

We are a leading marketer and provider of a weight management system based on a portion-controlled, prepared meal program. Typically, our customers purchase monthly food packages containing a 28-day supply of breakfasts, lunches, dinners and desserts, which they supplement with fresh dairy, fruit, salad, vegetables and low-glycemic carbohydrate items. Most of our customers order on an auto-delivery basis (“Auto-Delivery”), in which we send a month’s food supply on an ongoing basis until notified by the customer to stop our shipments. Our Auto-Delivery program is currently priced between $294 and $320 per shipment, or about $10 to $11 per day for a full 28 days of NutriSystem food. Our food is shelf stable at room temperature and will last for up to two years, making it relatively inexpensive to ship and store.

Our program is based on the following cornerstones that represent who we are to our customers:

Success. We believe our program enables our customers to lose weight successfully. Our NutriSystem ® Advanced™ program consists of over 100 portion-controlled food items that are designed to rank low on the Glycemic Index thereby providing dieters with a balanced intake of “good” carbohydrates, proteins and fats. The Glycemic Index is a measure of the quality of carbohydrates in foods. Foods on the lower end of the index are generally considered “good” carbohydrates.

Convenience. We sell our weight management programs primarily through a direct-to-consumer sales and distribution approach using the Internet and telephone. Our customers can order 24 hours a day, seven days a week on our website, www.nutrisystem.com, and the food is shipped directly to the customer’s door.

Simplicity. We provide a comprehensive weight management program, consisting of a pre-packaged food program and counseling. Our customers can either choose one of our pre-set food packages or customize their monthly food orders for their specific tastes. There are no center visits, no measuring foods or counting calories.

Value. Our Auto-Delivery program is currently priced at about $10 to $11 per day for a full 28 days of NutriSystem food. We do not charge membership fees.

Anonymity. The direct-to-consumer approach using the Internet provides the privacy that our customers value. We provide online and telephone counseling and support to our customers using our trained diet counselors resulting in no need to travel for a face-to-face meeting.

Competitive Strengths

We believe that our system offers consumers a sensible approach to losing weight without the use of faddish, unhealthy or unrealistic weight loss methods. We intend to capitalize on the following competitive strengths to grow:

Product Efficacy . We believe our customers are very satisfied with our products and believe they have lost weight while using our program. Our customer surveys found that clients lost an average of 1.5 to 2.0 pounds per week and tended to stay on the program for 10 to 11 weeks. We believe these surveys indicate overall satisfaction with our program and a willingness to refer our program to others.

Strong Brand Recognition . We believe that our brand is well recognized in the weight management industry. Our company and our predecessors have been in the weight management industry for more than 30 years, and we estimate that our company and our predecessors have spent hundreds of millions of dollars in advertising over that time period.

Low Cost, Highly Scalable Model . Unlike traditional commercial weight loss programs, which primarily sell through franchisee and company-owned centers, in our direct channel we generate revenue through the Internet and telephone. Our method of distribution removes the fixed costs and capital investment associated with diet centers. We also minimize fixed costs and capital investments in food procurement and fulfillment: we outsource the production of our food products to a number of vendors and we outsource approximately 90% of our fulfillment operations to a third-party provider.

Superior Consumer Value Proposition . Our goal is to offer our customers a complete weight management program that is convenient, private and cost-effective. Our customers place their orders through the Internet or over the phone and have their food delivered directly to their homes. This affords our customers the convenience and anonymity that other diets which rely on weight-loss centers cannot ensure. Additionally, we provide our customers with a month of food, including breakfast, lunch, dinner and dessert, each day, which removes the confusion of reading nutrition labels, measuring portions or counting calories, carbohydrates or points. At a cost of about $10 or $11 a day for a full 28 days of NutriSystem food, we believe our weight management program offers our customers significant value and is priced below those of our competitors. In addition, we do not charge a membership fee, whereas many of our competitors charge such a fee.

Our Industry

Weight management is a challenge for a significant portion of the U.S. population.

According to the U.S. Department of Health and Human Services, overweight or obese individuals are increasingly at risk for diseases such as diabetes, heart disease, certain types of cancer, stroke, arthritis, breathing problems and depression. However, there is evidence that weight loss may reduce the risk of developing these diseases.

In addition to the health risks, there are also cultural implications for those who are overweight or obese. U.S. consumers are inundated with imagery in media, fashion, and entertainment that depicts the thin body as the ideal type.

Despite the high percentage of overweight or obese individuals in the U.S., the popularity of dieting would seem to indicate consumers’ desire to be thin. According to Gallup surveys, approximately 45% or an estimated 99 million people in the United States were dieting during 2007. Of those, approximately 63 million people were attempting to lose weight and 36 million people were attempting to maintain their weight. Approximately 7% participated in commercial weight loss programs and 57% conducted some form of self-directed diet. We believe the NutriSystem program is well positioned to attract both types of dieters.

Competition

The weight loss industry is very competitive and consists of pharmaceutical products and weight loss programs, as well as a wide variety of diet foods and meal replacement bars and shakes, appetite suppressants and nutritional supplements. The weight loss market is served by a diverse array of competitors. Potential customers seeking to manage their weight can turn to traditional center-based competitors such as Weight Watchers, Jenny Craig and LA Weight Loss, online diet-oriented sites such as eDiets.com and WeightWatchers.com, self-administered products such as the over-the-counter drug Alli and programs such as Atkins and the South Beach Diet and medically supervised programs.

We believe that the principal competitive factors in the weight loss market are:


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the availability, convenience and effectiveness of the weight reduction program;


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brand recognition and trustworthiness;


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media spending;


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new products;


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program pricing; and


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the ability to attract and retain customers through promotion and personal referral.

Based on these factors, we believe that we can compete effectively in the weight management industry. We, however, have no control over how successful competitors will be in addressing these factors. By providing a well-recognized food-based program using the direct channel, we believe that we have a competitive advantage in our market.

Our Products and Services

For over 30 years, the NutriSystem name has been recognized as a leader in the weight loss industry. We provide a comprehensive weight management program, consisting primarily of a pre-packaged food program and counseling. Trained counselors are available an average of 24 hours per day, seven days per week, to answer questions and make recommendations to help each customer achieve his or her weight loss goals. Customers support, encourage and share information with each other through hosted chat rooms and bulletin boards. These services are complemented with relevant information on diet, nutrition and exercise, which is provided on our community website and emailed to our customers weekly.

In December 2007, we launched NutriSystem Advanced, our new weight-loss and health and wellness platform. NutriSystem Advanced is a complete program that includes new proprietary ingredient blends to support satiety and heart health. NutriSystem Advanced consists of over 100 food items, of which two meal categories (lunch and dessert) contain one of the two new NutriSystem proprietary blends of heart-healthy ingredients. Primary among these are OmegaSol™, a patent-pending combination of heart-healthy soluble fibers and omega-3 fatty acids that work to help promote a healthy heart while losing weight, and NutriSol™, an additional blend of soluble fibers that are naturally present in oats, fruits and whole grains and help reduce hunger and control appetite. NutriSystem Advanced continues to build upon the Glycemic Advantage™ by using “good carbs” in all of its foods. We have also worked to reduce the sodium content of the entire meal plan to an average of 1800mg per day and will continue to actively work to lower it without sacrificing flavor. With the changes made with the NutriSystem Advanced program, we are now fully compliant with the recommendations set forth by the American Heart Association approach to a healthy lifestyle. The NutriSystem Advanced program includes a personalized Results Kit that features a Mindset Makeover™ guide, an innovative approach to behavior modification which is compliant with research standards and co-authored by a national and international leader in the field of obesity research. This is an insightful and motivational behavior modification guide which walks clients through the program and can act as an interactive tool for our counselors to use in order to better facilitate communication and ultimately weight loss success for our clients. Renowned fitness experts Leslie Sansone and Vaughn Hebron have added to the heart benefits of NutriSystem Advanced by creating exercise DVDs exclusively for NutriSystem Advanced participants. The Results Kit also offers a customized meal planner, online community access information, a Quick Start Guide and more.

Typically, our customers purchase monthly food packages containing 28 breakfasts, lunches, dinners and desserts, which they supplement with fresh dairy, fruit, salad, vegetables and low-glycemic carbohydrate items. Most customers order on an auto-delivery basis in which we send food to the customers on a monthly basis until notified by the customer to cease shipments. With the Auto-Delivery program, a full day’s supply of entrees and desserts is currently priced at about $10 to $11 a day. The food is shelf stable at room temperature, making it relatively inexpensive to ship and store. On our website, customers can order food 24 hours a day, seven days a week.

The features of our weight loss program address many of the most common limitations of traditional weight loss programs, including high initiation and recurring membership fees, the inconvenience of traveling to weight loss centers for scheduled appointments and lack of privacy. In addition, our prepared meals provide our customers with a structured program in which they do not have to weigh or measure foods or count calories, carbohydrates or points.

Marketing

Our primary marketing objective is to cost-effectively promote our established brand and to build sales of our weight management program through our direct channel. We use a combination of online and traditional offline advertising and promotional strategies to accomplish this objective.

Offline Advertising . Offline advertising is used to encourage qualified customers to call or visit our website and increase awareness of the program. We reach our target audiences primarily through a combination of television, print and direct mail advertising. We use unique toll-free numbers and URLs to individually track the response of our advertisements. On television and in print, direct response-focused advertisements capitalize on our brand name and focus on “before and after” comparisons and/or the program’s simplicity, convenience and “good carbohydrate” features. Direct mail and outbound telemarketing are companions to the media advertising and consist of mailings and calls to direct customers who have purchased or others who have signed up for access to our services.

Online Advertising . Our online advertising strategy is based on driving high volume, cost-effective qualified leads to the site with a focus on increasing both front and back end conversion through constant testing and optimization. We are continually exploring new online opportunities as the market changes and grows, but focus the majority of our efforts on search optimization (paid and natural), affiliate management, portal relationships, large ad networks, strategic partnerships, targeted display media and internal/external email campaigns.

Public Relations . We have generated brand awareness for our program in a variety of media including television, magazines, newspapers and on the Internet. For example, our media relations success includes receiving favorable mentions in national consumer media such as: People Magazine , Ladies Home Journal , Entertainment Tonight , Good Housekeeping , The New York Times , US Weekly , Women’s Day , Access Hollywood and The Tonight Show .

Moreover, we have promoted our brand and product through celebrity spokespersons who also appear in our advertising, such as Marie Osmond, Tori Spelling, Joey Fatone, ANT, Tony Orlando, Dan Marino, Mike Golic and Coach Shula and third party endorsements that have appeared on television shows including, Dancing with the Stars, VH-1 Celebrity Fit Club, The Today Show, Larry King Show, NFL Today and CBS Morning Show.

Sales and Counseling

A majority of our direct business sales occur on our website. The remaining sales are by telephone, and our call center processes virtually all of them. Our weight loss program is also sold through QVC, a television home shopping network, which represented 5% of revenue in 2007.

As of December 31, 2007, we employed approximately 130 weight loss counselors and 215 sales agents. Staffing levels for counselors and sales agents are largely a function of the volume of revenue and orders. Sales agents are responsible for in-bound sales calls and will initiate out-bound sales calls to our leads and other targeted potential customers. Counselors handle some in-bound sales calls but primarily focus on in-bound counseling calls, email and voicemails. Counselors also handle online web conversations from new visitors and appointments with existing customers. Sales agents and counselors are available 24 hours per day, seven days a week. Sales agents are paid primarily on commission while counselors receive an hourly wage.

We seek to hire counselors with backgrounds in psychology, sociology, nutrition, dietetics or other health-related fields and with suitable temperaments to talk with our customers. Our counselors are more experienced and have more training than our sales agents. Counselors are trained in our meal plan, our Internet chat service, email, voicemail, motivational techniques and customer service problem solving.

Customer Service

As of December 31, 2007, we employed approximately 120 customer service representatives. Customer service representatives are trained to handle in-bound calls and email from customers who have questions or problems with an order after the sale transaction is completed. Typical customer inquiries relate to arrival date of their order shipment, report of missing or damaged items and credits and exchanges. For email inquiries, we have a software system that scans the customer’s email message for key words and automatically supplies the representative with a form response that is reviewed, edited and sent back to the customer. Customer service representatives are typically available from 8 a.m. to 12 midnight, Monday through Friday, and 8:30 a.m. to 5 p.m. on Saturday and Sunday. Customer service representatives are paid an hourly wage.

Fulfillment

We operate an integrated order receipt, billing, picking, shipping and delivery tracking system comprised of proprietary and third party components. This system integrates the front end, or website customer interface, with order processing and shipping, and allows Internet customers to access shippers’ order tracking numbers online. Our computer-assisted picking system allows for virtually paperless order picking in all warehouse facilities. In 2006 and 2007, we engaged in multiple projects designed to increase processing capabilities and provide greater operational flexibility and control within this integrated shipping system. Management believes these improvements provide reasonable assurance that our growth will continue to be supported.

We operate an integrated network of distribution facilities of which one is company-owned and six are outsourced. In 2007, approximately 90% of our fulfillment was handled by our outsourced provider. In 2006 and 2007, we completed an expansion and redesign of our warehouse network. These changes ensure higher volume capabilities while simultaneously reducing process/delivery times and outbound freight costs. In 2007, approximately 99% of all direct customer orders were shipped within two business days of the day received. In addition, we can ship to approximately 99% of the domestic population within four business days using standard ground transportation. Direct customers are not charged for their orders until the ordered product is shipped. We do not charge customers for shipping and handling on Auto-Delivery food orders.

Product Development

All of our foods and supplements are currently outsourced from more than 30 manufacturers or vendors. Our product development department primarily creates ideas and concepts based on customer feedback, market trends, nutrition and food technology breakthroughs and retail grocery trends. This starts at the laboratory level to determine if the product can meet our stringent demands (i.e. shelf stable, glycemic friendly, etc.) and is then outsourced to our food manufacturers who further develop the new product based on our specifications. All new foods are created to enhance the variety of our current program, or to support the efforts of creating a new program. Also, new foods are presented to us by food manufacturers to see if they are compatible with our program. Most of our foods are created from market research and customer requests, as well as recommendations from our manufacturers. All of our new foods are evaluated for nutrition, compliance with our program, taste (by using testing panels) and cost considerations. The number of SKUs we introduce each year varies depending on whether we are introducing a new program, like NutriSystem Advanced, where over 60 new items were created, or updating an existing program, where approximately 20 new products are typically introduced.

Our Customers

Based on our customer data, our typical customer is female, approximately 48 years of age and weighs 185 lbs. In January 2006, we initiated advertising programs directed toward men. As a result, men comprised approximately 31% of our new customers in 2007 compared to 24% in 2006 and 13% in 2005. In early 2007, we also began to market to seniors in television advertising. We believe that, on average, our customers want to lose approximately 45 lbs. over a period of time. Based on our customer surveys, we believe our typical customers tend to stay on our program for 10 to 11 weeks (including the one free week most customers obtain with their initial order), lose 1.5 to 2.0 pounds per week and have tried other popular diet programs. We believe that these surveys indicate a willingness to refer our program to others and that our customers value the following NutriSystem program attributes:


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effective weight loss;


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direct delivery to their door;


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easy to follow;


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food can be easily prepared in minutes;


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wide variety of food; and


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they do not feel hungry while on the program.

Information Systems

Our ecommerce and community websites, both of which are based on internally developed software and other third party software, are each hosted in a top tier, co-location facility. These facilities provide redundant network connections, an uninterruptible power supply, physical and fire security and diesel generated power back up for the equipment upon which our website relies. Our servers and our network are monitored 24 hours a day, seven days a week.

We use a variety of security techniques to protect our confidential customer data. When our customers place an order or access their account information, we use a secure server (SSL) to transfer information. Our secure server software encrypts all information entered before it is sent to our server. All customer data is protected against unauthorized access. We use VeriSign and CyberSource software to secure our credit card transactions.

Intellectual Property

We own numerous domestic and international trademarks and other proprietary rights that are important to our business. Depending upon the jurisdiction, trademarks are valid as long as they are used in the regular course of trade and/or their registrations are properly maintained. We believe the protection of our trademarks, copyrights, patents, domain names, trade dress, and trade secrets important to our success. We aggressively protect our intellectual property rights by relying on a combination of trademark, copyright, patent, trade dress and trade secret laws, and through the domain name dispute resolution system.

Employees

As of December 31, 2007, we had approximately 602 administrative, sales, counseling and customer service personnel, 87 employees dedicated to fulfillment and 47 employees in marketing. None of our employees is represented by a labor union, and we consider relations with our employees to be good.

Seasonality

Typically in the weight loss industry, revenue is strongest in the first quarter and lowest in the fourth calendar quarter. We believe our business experiences seasonality, driven by the predisposition of dieters to initiate a diet and the placement of our advertising based on the price and availability of certain media. This seasonality can be seen in our results for 2007, however, in 2005, our revenue increased sequentially every quarter due to our increased level of advertising spending and, in 2006, revenue in the third quarter was higher than revenue in the first quarter due in part to favorable conditions in the market for certain media.

CEO BACKGROUND

Michael J. Hagan has served as the Chairman of our Board and as our Chief Executive Officer since December 2002. He also served as our President from July 2006 to September 2007. Prior to joining us, Mr. Hagan was the co-founder of Verticalnet, Inc., a business-to-business Internet and software company, and held a number of executive positions at Verticalnet, Inc. since its founding in 1995, including Chairman of the Board from February 2002 to May 2005, President and Chief Executive Officer from January 2001 to February 2002, Executive Vice President and Chief Operating Officer from January 2000 to January 2001 and Senior Vice President prior to that time. Mr. Hagan is also a director of Internet Capital Group, Inc.

Joseph M. Redling has served as our President and Chief Operating Officer since September 2007. Prior to joining us, Mr. Redling held a number of executive positions at AOL, Inc., a global web services company, including Chief Marketing Officer, President of AOL Access, President of AOL Paid Services and Customer Management and Chief Executive officer of AOL International from September 2001 through March 2007.

David D. Clark has served as our Senior Vice President, Chief Financial Officer, Secretary and Treasurer since November 2007. Prior to joining us, Mr. Clark was Chief Financial Officer of Claymont Steel Holdings, Inc., a manufacturer of steel plate from November 2006 through October 2007. Prior to that Mr. Clark was Chief Financial Officer of SunCom Wireless Holdings, a provider of digital wireless communications services, from its founding in 1997 through February 2006 and held the additional position of Executive Vice President from 2000 through February 2006 and Senior Vice President from 1997 through 2000.

Thomas F. Connerty has served as our Chief Marketing Officer since November 2004 and our Executive Vice President, Program Development since July 2006. Prior to joining us, Mr. Connerty was the Vice President of Marketing at the Nautilus Group, a retailer of commercial and home use fitness equipment, including the Bowflex Home Gym, from 1999 to 2004.

Bruce Blair has served as our Senior Vice President, Operations and Chief Information Officer since April 2005. Prior to joining us, Mr. Blair was the Chief Information Officer and Executive Vice President of Creditek, a finance and accounting outsourcing firm from March 2003 to March 2005. Before Creditek, Mr. Blair was the President of GovXcel, a leading application provider of software used by municipalities to automate back office functions, from January 2001 to December 2001. He also served as Chief Information Officer and Senior Vice President of Operations at Verticalnet, Inc. from March 1999 to December 2000.

MANAGEMENT DISCUSSION FROM LATEST 10K

Background

We provide weight management and fitness products and services. Our pre-packaged foods are sold to weight loss program participants directly via the Internet and telephone, referred to as the direct channel, and through independent commissioned representatives, the field sales channel, through independent center-based distributors, the case distributor channel, and through QVC, a television shopping network. In 2007, substantially all of our revenue was generated domestically. In January 2008, we expanded operations into Canada and expect to enter the United Kingdom and Japan by 2009.

Revenue consists primarily of food sales. For the year ended December 31, 2007, the direct channel accounted for 94% of total revenue compared to 5% for QVC and 1% for the other channels. We incur significant marketing expenditures to support our brand. We believe that our brand is continuing to gain awareness as we continue to increase our purchases of media in all media channels. New media channels are tested on a continual basis and we consider our media mix to be highly diverse. We market our weight management system through television, print, direct mail, Internet and public relations.

We review and analyze a number of key operating and financial metrics to manage our business, including the number of new customers, revenue per customer, total revenues, marketing per new customer, operating margins and reactivation revenue. In 2007, we continued to focus on these metrics and expanded our efforts with integrated database marketing, increased market segmentation with women, men and seniors and new and deeper marketing channel exploration. We focused not only on the acquisition of customers but also on the retention and reactivation of customers. We looked to improve the online experience with the member section of our website which, we believe, should provide a more valuable, effective and interactive experience and increase the level of weight loss support that we offer with our program to our customers.

In December 2007, we launched NutriSystem Advanced, a new weight-loss and health and wellness platform, that replaced NutriSystem Nourish, which was our core weight loss program since 2004. We believe this program to be easier and healthier than NutriSystem Nourish and will aid in our reactivation efforts as it gives our lapsed customers a reason to try us again. In order to transition from NutriSystem Nourish to NutriSystem Advanced, we incurred approximately $3.7 million of costs in the fourth quarter of 2007 primarily associated with inventory, higher shipping costs and less efficiency in our fulfillment operations and spent additional marketing dollars directed toward the launch of this new program.

In the fourth quarter of 2007, we committed to a plan to sell our subsidiary, Slim and Tone, a franchisor of women’s express fitness centers. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” this subsidiary has been treated as a discontinued operation. Accordingly, the operating results of this discontinued operation have been presented separately from continuing operations. In accordance with SFAS No. 144, we compared the fair value of Slim and Tone and determined the net carrying value was impaired by $1.2 million pre-tax, which is included in the loss on discontinued operation. Slim and Tone had revenues of $723,000, $2.3 million and $2.3 million and pre-tax losses of $100,000, $874,000 and $1.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.

We are seeing a challenging environment develop in 2008, with some consumers reducing spending on discretionary type items, which we believe includes commercial weight loss products. Operating in this environment will require a flexible business model but we believe our core product offering and brand not only remain healthy but continue to show strength. In 2008, we will continue to focus on reactivation revenue and will increase our marketing to support this growing revenue stream. We will also look to develop new programs to focus on revenue per customer and extending length of stay. A new maintenance program is in development to extend the paying relationships beyond the initial weight loss phase and we are expecting to expand into a frozen line of entrees to supplement the basic meal plan and provide more variety and choices. To address the current economic challenges, we are testing a number of new offers and value enhancements to give our customers a better reason to try us. Additionally, we are launching new creative as well as featuring new celebrity spokespersons and will continue to manage our media spend to optimize profitability and to ensure we are capitalizing on all efficiencies.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles. Our significant accounting policies are described in Note 2 of the consolidated financial statements included in Item 8.

The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Management develops, and changes periodically, these estimates and assumptions based on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Management considers the following accounting estimates to be the most critical in preparing our consolidated financial statements. These critical accounting estimates are discussed with our audit committee quarterly.

Reserves for Returns . We review the reserves for customer returns at each reporting period and adjust them to reflect data available at that time. To estimate reserves for returns, we consider actual return rates in preceding periods and changes in product offerings or marketing methods that might impact returns going forward. To the extent the estimate of returns is inaccurate, we will adjust the reserve, which will impact the amount of product sales revenue recognized in the period of the adjustment. The provision for estimated returns for the years ended December 31, 2007, 2006 and 2005 were $57.2 million, $39.6 million and $15.7 million, respectively. The reserve for returns incurred but not received and processed was $2.9 million and $2.6 million at December 31, 2007 and 2006, respectively, and has been included in other accrued expenses and current liabilities in the accompanying consolidated balance sheet.

Vendor Rebates. One of our suppliers provides for rebates based on purchasing levels. We accrue this rebate as purchases are made at a rebate percentage determined based upon the estimated total purchases from the vendor. The estimated rebate is recorded as a reduction in the carrying value of purchased inventory and is reflected in the consolidated statement of operations when the associated inventory is sold. A receivable is recorded for the estimate of the rebate earned. The actual rebate received from the vendors has closely matched the estimated rebate recorded and an adjustment is made to the estimate upon determination of the final rebate. The rebate period is June 1 through May 31 of each year. For the years ended December 31, 2007, 2006 and 2005, we reduced cost of revenue by $5.3 million, $4.4 million and $1.9 million, respectively, for these rebates. A receivable of $3.7 million and $3.2 million at December 31, 2007 and 2006, respectively, has been recorded in receivables in the accompanying consolidated balance sheet.

Excess and Obsolete Inventory. We continually assess the quantities of inventory on hand to identify excess or obsolete inventory and record a provision for the potential loss. We estimate the reserve for excess and obsolete inventory based primarily on our forecasted demand and/or our ability to sell the products, future production requirements and changes in our customers’ behavior. The reserve for excess and obsolete inventory was $516,000 and $450,000 at December 31, 2007 and 2006, respectively.

Income Taxes . For the year ended December 31, 2007, we recorded income tax expense of $60.9 million, which reflected an effective income tax rate of 36.7%. For the year ended December 31, 2006, we recorded $51.0 million of income taxes, which reflected an effective income tax rate of 37.3%. We estimate the annual effective income tax rate at the beginning of each year and revise the estimate at each reporting period based on a number of factors including operating results, level of tax exempt interest income and sales by state, among other items.

Results of Operations

Revenue and expenses consist of the following components:

Revenue. Revenue consists primarily of food sales. Food sales include sales of food, supplements, shipping and handling charges billed to customers and sales credits and adjustments, including product returns. No revenue is recorded for food products provided at no charge as part of promotions.

Cost of Revenue . Cost of revenue consists primarily of the cost of the products sold, including compensation related to fulfillment, the costs of outside fulfillment, incoming and outgoing shipping costs, charge card fees and packing material. Cost of products sold includes products provided at no charge as part of promotions and the non-food materials provided with customer orders. Cost of revenue also includes the fees paid to independent distributors and sales commissions.

Marketing Expenses . Marketing expense includes media, advertising production, marketing and promotional expenses and payroll-related expenses for personnel engaged in these activities. We follow the American Institute of Certified Public Accountants Statement of Position 93-7, “Reporting on Advertising Costs.” Internet advertising expense is recorded based on either the rate of delivery of a guaranteed number of impressions over the advertising contract term or on a cost per customer acquired, depending upon the terms. Direct-mail advertising costs are capitalized if the primary purpose was to elicit sales to customers who could be shown to have responded specifically to the advertising and results in probable future economic benefits. The capitalized costs are amortized to expense over the period during which the future benefits are expected to be received. All other advertising costs are charged to expense as incurred.

General and Administrative Expenses . General and administrative expenses consist of compensation for administrative, information technology, counselors (excluding commissions) and customer service personnel, share-based payment arrangements, facility expenses, website development costs, professional service fees and other general corporate expenses.

Equity Loss. Equity loss consists of our share of the earnings or losses of our equity interests. We hold an approximate 27% interest in Zero Technologies, LLC (“Zero Water”) and have the ability to significantly influence the operations of Zero Water. The investment in Zero Water is accounted for using the equity method of accounting.

Interest Income, Net. Interest income, net consists of interest income earned on cash balances and marketable securities, net of interest expense.

Income Taxes. We are subject to corporate level income taxes and record a provision for income taxes based on an estimated effective income tax rate for the year.

Overview of the Direct Channel

In the years ended 2007, 2006 and 2005, the direct channel represented 94%, 93% and 90%, respectively, of our revenue. Revenue increases are primarily driven by new customer growth. Critical to acquiring new customers is our ability to increase our marketing spend while maintaining marketing effectiveness. Our spending on advertising and marketing to new customers increased by $59.3 million to $175.5 million in 2007 from $116.2 million in 2006. Factors influencing our marketing effectiveness include the quality of the advertisements, promotional activity by our competitors, along with the price and availability of appropriate media. In addition to our marketing efforts, we generate new customers through referrals and publicity, such as magazine articles and mentions on television. We also advertise to our former customers. In the years ended 2007 and 2006, $3.2 million and $1.9 million, respectively, of our total marketing expense was spent to reach former customers. When former customers return to the program and, as the number of former customers grows, we generate an increasing amount of revenue from these returning customers. We refer to revenue derived from returning customers more than nine months removed from their initial purchase as reactivation revenue.

We measure growth in terms of total revenue, new customers and revenue per customer. A new customer is defined as a first-time purchaser through the direct channel. We define a customer with an initial purchase of $100 or more to be a new “program” customer. These customers tend to stay on a weight loss program longer and spend substantially more than customers who make an initial purchase of less than $100. Program customers made up 99%, 99% and 97% of all new customers, with average marketing cost per program customer of $186, $147 and $140, in 2007, 2006 and 2005, respectively. Profit margins are measured in terms of gross margin (revenue less cost of revenue) and total marketing expense as a percentage of revenue. We evaluate the cost effectiveness of our marketing programs based on the marketing cost per new customer acquired. When calculating new customer acquisition cost, we exclude the marketing expense spent to reach former customers. Prior to 2006 this spend was immaterial.

Direct revenue increased 38% in 2007 from 2006. In 2007, the number of new customers acquired increased by 156,067 or 20%, over 2006. The increase in new customers is primarily attributable to higher marketing spending. Marketing to new customers increased $59.3 million, or 51% in 2007 compared to 2006. Overall marketing spend per new customer was $184 in 2007 compared to $146 in 2006. Direct revenue increased 178% in 2006 from 2005. In 2006, new customers increased by 450,269, or 130%, over 2005. In 2006, marketing to new customers increased $68.8 million, or 145% compared to 2005.

Direct gross margin increased to 54.8% in 2007 from 54.2% in 2006, primarily driven by a price increase, lower outbound freight costs, a lower customer return rate and lower fulfillment costs. Direct gross margin increased to 54.2% in 2006 from 51.6% in 2005, primarily driven by a 3.5% price increase.

Marketing cost per customer increased from $146 to $184 from 2006 to 2007. Marketing cost per program customer increased from $147 to $186 in the same periods. The higher marketing cost per customer can be attributed to the significant increase in marketing spend and increased competition.

We analyze revenue per customer across two cycles. The first cycle is defined as the initial diet cycle and refers to revenue obtained within nine months of a customer’s initial purchase divided by the new customer count for each of the last nine months. For reporting purposes, we use the average revenue per customer computed in the trailing nine months. Generally, revenue per customer in the initial diet cycle has been increasing. The trailing nine month revenue per customer was $605, $632 and $648 for December 31, 2005, 2006 and 2007, respectively. We believe these increases are primarily driven by the price increases and by increased unit purchases per customer.

The second cycle is referred to as reactivation revenue and is defined as customers who were more than nine months removed from their initial purchase. Reactivation revenue contributed approximately $95.5 million to revenue in 2007 compared to $37.8 million to revenue in 2006. Reactivation revenue is increasing primarily due to the increasing number of former customers. We believe that reactivation revenue is particularly profitable because a relatively low marketing expense is incurred to generate this revenue.

Overview of Distribution via a Television Home Shopping Network

We distribute our proprietary prepackaged food through QVC, a television home shopping network. In 2007, this channel represented 5% of our revenue as compared to 6% of our revenue in 2006 and 7% in 2005. On the QVC network, we reach a large audience in a 50-minute infomercial format that enables us to fully convey the benefits of the NutriSystem diet programs. Under the terms of our agreement, QVC viewers purchase NutriSystem products directly from QVC and are not directed to the NutriSystem website. Retail prices (including shipping and handling) offered on QVC to consumers are similar to prices offered on the website. We generate a lower gross margin (as a percent of revenue) on sales through QVC relative to the direct channel, but QVC sales require no incremental advertising and marketing expense and, management believes, exposure on QVC raises consumer awareness of the NutriSystem brand. Net sales through QVC were $41.1 million in 2007, $31.3 million in 2006 and $15.6 million in 2005. QVC sales are a function of the number of shows and the sales per minute on each show. Sales increased in 2007 versus 2006 and 2005 because the sales per minute of air-time increased.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

Revenue. Revenue increased to $776.8 million for the year ended December 31, 2007 from $566.0 million for the year ended December 31, 2006. The revenue increase resulted primarily from increased direct sales ($200.9 million) and QVC sales ($9.8 million). Revenue growth in the first half of 2007 was strong yet the second half of 2007 was impacted by competitive and economic pressures. In the year ended December 31, 2007, direct revenue accounted for 94% of total revenue compared to 5% for QVC and 1% for the other channels. In 2006, the comparable percentages were 93%, 6% and 1%, respectively.

Costs and Expenses. Cost of revenue increased to $363.9 million for the year ended December 31, 2007 from $270.6 million for the year ended December 31, 2006. Gross margin as a percent of revenue increased to 53.2% in 2007 from 52.2% in 2006. The increase in gross margin was primarily attributable to price increases, lower outbound freight costs, a lower customer return rate and lower fulfillment costs.

Marketing expenses increased to $178.7 million in 2007 from $118.2 million in 2006. Marketing expense as a percent of revenue increased to 23.0% in 2007 from 20.9% in 2006. Substantially all of the marketing spending promoted the direct business, and the increase in marketing is attributable to increased spending for advertising media ($51.4 million), public relations ($2.7 million) and production of television advertising ($1.9 million). In total, media spending was $162.7 million in 2007 and $111.3 million in 2006.

General and administrative expenses increased to $65.5 million in 2007 from $41.7 million in 2006 and as a percent of revenue increased to 8.4% in 2007 from 7.4% in 2006. The increase in spending is primarily attributable to higher compensation and benefits costs ($8.5 million) due to an increased headcount and the hiring of two executive officers in 2007; increased professional, recruiting and outside services and computer services ($9.0 million) in part for projects to improve our ecommerce website and support for international expansion and increased depreciation and amortization expense ($3.3 million) due to increased capital expenditures on our website and a call center relocation.

Other Expense. Other expense represents the realized gains and losses from currency.

Equity Loss. In October 2007, we purchased an approximate 27% equity interest in Zero Water, a manufacturer of patented water filters. This investment is accounted for under the equity method of accounting and an estimated loss of $800,000 was recorded for our share of Zero Water’s loss subsequent to the initial investment.

Interest Income, Net. Interest income, net increased to $3.8 million in 2007 from $3.6 million in 2006 primarily due to higher cash balances maintained for the majority of the year.

Income Taxes. In 2007, we recorded income tax expense of $60.9 million, which reflects an estimated annual effective tax rate of 36.7%. In 2006, we recorded $51.0 million of income tax expense for the reporting period. The effective tax rate in 2006 was 37.3%. The decrease in the effective tax rate was primarily due to lower state income taxes due to the apportionment of income to states with lower tax rates and food donations.

Net Income. For the year ended December 31, 2007, net income increased to $104.2 million from net income of $85.1 million in 2006. The increase in net income in 2007 is primarily due to higher gross profit in 2007 versus 2006 resulting from increased revenue which offset the higher advertising and marketing spending, general and administrative expenses and income taxes.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Results of Operations

Revenue and expenses consist of the following components:

Revenue. Revenue consists primarily of food sales. Food sales include sales of food, supplements, shipping and handling charges billed to customers and sales credits and adjustments, including product returns. No revenue is recorded for food products provided to customers at no charge as part of promotions.

Cost of Revenue . Cost of revenue consists primarily of the cost of the products sold, including the compensation related to fulfillment, the costs of outside fulfillment, incoming and outgoing shipping costs, charge card fees and packing material. Cost of products sold includes products provided at no charge as part of promotions and the non-food materials provided with customer orders. Cost of revenue also includes the fees paid to independent distributors and sales commissions.

Marketing Expense . Marketing expense includes media, advertising production, marketing and promotional expenses and payroll-related expenses for personnel engaged in these activities. We follow the American Institute of Certified Public Accountants Statement of Position 93-7, “Reporting on Advertising Costs.” Internet advertising expense is recorded based on either the rate of delivery of a guaranteed number of impressions over the advertising contract term or on a cost per customer acquired, depending upon the terms. Direct-mail advertising costs are capitalized if the primary purpose was to elicit sales to customers who could be shown to have responded specifically to the advertising and results in probable future economic benefits. The capitalized costs are amortized to expense over the period during which the future benefits are expected to be received. All other advertising costs are charged to expense as incurred.

General and Administrative Expenses . General and administrative expenses consist of compensation for administrative, information technology, counselors (excluding commissions) and customer service personnel, share-based payment arrangements, facility expenses, website development costs, professional service fees and other general corporate expenses.

Equity Loss. Equity loss consists of our share of the earnings or losses of our equity interests including any amortization expense for the difference between the cost and the underlying equity in net assets of the equity interest at the date of investment. We hold an approximate 27% interest in Zero Technologies, LLC (“Zero Water”) and have the ability to significantly influence the operations of Zero Water. The investment in Zero Water is accounted for using the equity method of accounting.

Interest Income, Net. Interest income, net consists of interest income earned on cash balances and marketable securities, net of interest expense.

Income Taxes. We are subject to corporate level income taxes and record a provision for income taxes based on an estimated annual effective income tax rate for the year.

Overview of the Direct Channel

In the three months ended March 31, 2008 and 2007, the direct channel represented 93% and 91%, respectively, of our revenue. Revenue is primarily driven by new customer growth, returning customers and revenue per customer. Critical to acquiring new customers is our ability to increase our marketing spend while maintaining marketing effectiveness. Factors influencing our marketing effectiveness include the quality of the advertisements, promotional activity by our competitors, along with the price and availability of appropriate media. In addition to our marketing efforts, we generate new customers through referrals and publicity, such as magazine articles and mentions on television. We also advertise to our former customers. When former customers return to the program and, as the number of former customers grows, we generate an increasing amount of revenue from these returning customers. We refer to revenue derived from returning customers more than nine months removed from their initial purchase as reactivation revenue. Net sales through the direct channel were $200.6 million and $217.9 million for the three months ended March 31, 2008 and 2007, respectively. The decrease is primarily attributable to the decline in customer starts due to the weakening economy.

Overview of Distribution via a Television Home Shopping Network

We distribute our proprietary prepackaged food through QVC, a television home shopping network. In the three months ended March 31, 2008 and 2007, this channel represented 6% and 7% of our revenue, respectively. On the QVC network, we reach a large audience in a 50 minute infomercial format that enables us to fully convey the benefits of the NutriSystem diet programs. Under the terms of our agreement, QVC viewers purchase NutriSystem products directly from QVC and are not directed to the NutriSystem website. Retail prices (including shipping and handling) offered on QVC to consumers are similar to prices offered on the website. We generate a lower gross margin (as a percent of revenue) on sales through QVC relative to the direct channel, but QVC sales require no incremental advertising and marketing expense and, management believes, exposure on QVC raises consumer awareness of the NutriSystem brand. Net sales through QVC were $14.1 million and $17.6 million for the three months ended March 31, 2008 and 2007, respectively. QVC sales are a function of the number of shows and the sales per minute on each show. Sales decreased for the three months ended March 31, 2008 versus the comparable period of 2007, following a similar trend as the direct channel. Sales in January were slower than expected yet the second half of the quarter showed improvement.

Three Months Ended March 31, 2008 Compared to Three Months Ended March 31, 2007

Revenue. Revenue decreased to $216.5 million in the first quarter of 2008 from $238.1 million for the first quarter of 2007. The revenue decrease resulted primarily from a decrease in customer starts due to the weakening economy, which was partially offset by the improvement in revenue per customer. The direct channel accounted for 93% of total revenue in the first quarter of 2008 compared to 6% for QVC and 1% for other channels. In the first quarter of 2007, the direct channel accounted for 91% of total revenue compared to 7% for QVC and 2% for other channels.

Costs and Expenses. Cost of revenue decreased to $107.2 million in the first quarter of 2008 from $111.5 million in the first quarter of 2007. Gross margin as a percent of revenue decreased to 50.5% in the first quarter of 2008 from 53.2% for the first quarter of 2007. The decrease in gross margin was primarily attributable to increased food and freight costs. We will continue to focus on these costs and are working in partnership with our vendors to apply cost saving measures to help mitigate these pressures.

Marketing expense increased to $67.3 million in the first quarter of 2008 from $51.7 million in the first quarter of 2007. Marketing expense as a percent of revenue increased to 31.1% in the first quarter of 2008 from 21.7% for the first quarter of 2007. We invested more marketing dollars early in the quarter to maintain our position in a competitive media environment and to support the launch of NutriSystem Advanced. Towards the latter half of the quarter, we were able to reallocate resources to our higher performing channels and media outlets and improve marketing efficiency. Substantially all marketing spending during the quarter promoted the direct business, and the increase in marketing is primarily attributable to increased spending for advertising media ($11.9 million) and the production of television advertising ($2.8 million). In total, media spending was $60.9 million in the first quarter of 2008 and $49.0 million in the first quarter of 2007.

General and administrative expenses increased to $16.7 million in the first quarter of 2008 compared to $14.3 million in the first quarter of 2007. General and administrative expense as a percent of revenue increased to 7.7% in the first quarter of 2008 from 6.0% for the first quarter of 2007. The increase in spending is due to increased professional and outside services expenses ($2.2 million) in part for maintenance and support of our ecommerce website, increased depreciation and amortization expense ($822,000) due to the increased capital expenditures in 2007 and increased telephone and internet expense ($545,000); which offset a decrease in compensation and benefits costs ($786,000).

Other Expense. Other expense represents the realized gains and losses from currency.

Equity Loss. In October 2007, we purchased an approximate 27% equity interest in Zero Water, a manufacturer of patented water filters. This investment is accounted for under the equity method of accounting and an estimated loss of $1.2 million was recorded for our share of Zero Water’s loss and the amortization expense for the difference between cost and the underlying equity in net assets of Zero Water.

Interest Income, Net. Interest income, net, decreased to $248,000 in the first quarter of 2008 compared to $959,000 in the first quarter of 2007. The decrease in interest income, net is due to lower cash balances and lower interest rates as excess cash was invested in bank and money market accounts during 2008.

Income Taxes. In the first quarter of 2008, we recorded income tax expense of $8.3 million, which reflects an estimated annual effective income tax rate of 37.0%. In the first quarter of 2007, we recorded income tax expense of $22.7 million, which reflected an estimated annual effective income tax rate of 37.5%. The decrease in the effective tax rate is primarily due to food donations.

Net Income. Net income decreased to $14.1 million in the first quarter of 2008 compared to $37.9 million in the first quarter of 2007. The decrease in net income is primarily due to the decrease in revenue, higher food and freight costs and less efficient advertising and marketing spending.

Contractual Obligations and Commercial Commitments

As of March 31, 2008, our principal commitments consisted of obligations under supply agreements with food vendors, an agreement with our outside fulfillment provider, a capital lease, operating leases and employment contracts. Although we have no material commitments for capital expenditures, we anticipate continuing requirements for capital expenditures consistent with anticipated growth in operations, infrastructure and personnel.

During the three months ended March 31, 2008, there were no items that significantly impacted our commitments and contingencies as disclosed in the notes to the consolidated financial statements for the year ended December 31, 2007, as included in our Form 10-K. In addition, we have no off-balance sheet financing arrangements.

Liquidity, Capital Resources and Other Financial Data

At March 31, 2008, we had net working capital of $76.8 million, compared to net working capital of $103.3 million at December 31, 2007. Cash and cash equivalents at March 31, 2008 were $43.0 million, an increase of $2.3 million from the balance of $40.7 million at December 31, 2007. Additionally, we had $1.8 million invested in marketable securities at December 31, 2007. There were no marketable securities as of March 31, 2008. In the three months ended March 31, 2008, we used $41.2 million to repurchase 3.3 million shares of our common stock. Our principal sources of liquidity during this period were cash flows from operations. We have a $200.0 million unsecured revolving credit agreement with a group of lenders, which is committed until October 2, 2012 with an expansion feature, subject to certain conditions, to increase the facility to $300.0 million. During the three months ended March 31, 2008, we drew down $35.0 million against this facility but, as of March 31, 2008, no amounts were outstanding. We currently have no off-balance sheet financing arrangements.

In the three months ended March 31, 2008, we generated a cash flow of $43.1 million from operations, a decrease of $22.9 million from 2007. The decrease in cash flow from operations is primarily attributable to the decline in net income. Net changes in operating assets and liabilities increased cash flow from operations by $25.4 million in 2008, with changes due to the reduction in inventories ($12.1 million) and increases in accounts payable ($7.1 million) due to increased marketing spending towards the end of the quarter and income taxes ($6.3 million).

In the three months ended March 31, 2008, net cash used by investing activities was $503,000, primarily due to capital expenditures of $2.3 million, which offset the cash received from the sales of marketable securities of $1.8 million. We are continuing to invest in our ecommerce platform and web initiatives which will allow us to enhance our sales efforts and be more efficient in testing and in offering new promotional programs.

In the three months ended March 31, 2008, net cash used in financing activities consisted of the repurchase of 3.3 million shares of our common stock for an aggregate purchase price of $41.2 million, which was partially offset by the tax benefit from stock option exercises and cash receipts from the exercise of common stock options.

In August 2006, we announced that our Board of Directors authorized the repurchase of up to $50 million of our outstanding shares of common stock. In February 2007, a repurchase program of up to $200 million of our outstanding shares of common stock was authorized and, in October 2007, an additional $100 million was authorized. The stock repurchase programs from 2007 have an expiration date of March 31, 2009 and also may be limited or terminated at any time without prior notice. The repurchased shares have been retired.

The Board of Directors also declared the Company’s first quarterly dividend of $0.175 per share, payable May 15, 2008 to shareholders of record as of May 5, 2008. The Company intends to continue to pay regular quarterly dividends; however, the declaration and payment of future dividends are discretionary and will be subject to quarterly determination by the Board of Directors following its review of the Company’s financial performance.

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