Lessons learned: Faulty market logic

A mistake that I repeatedly make is falling for lucrative markets.

One such mistake was with obesity. The problem with the world wide obesity epidemic from an investor’s point of view is that everybody knows its an epidemic and everybody wants to get a piece of those fat future profits.

I bought in to this story when I thought I had found solid fundamentals in Nutrisystem (NTRI). The company was profitable and generated a decent amount of free cash flow without significant leverage (it still is today but to a lesser extent). From an operating point of view the company is very focused on providing a strong value proposition for its customers and it has gained recognition as providing just that.

On the flip side, I wasn’t totally ignorant about the weaknesses of my conjecture. Nutrisystem basically generates its revenue by advertising a whole lot in an effort to sell their product to dieters. Those dieters get on a 28 day program to loose significant weight, which is to be reordered until the weight target is reached. But after that the relationship is over until perhaps the client gains weight again. Needless to say, most of its business is done after people renew their new year’s resolutions. It seems to me that a business model of Herbalife (although I dislike MLM systems) in which a client starts a long term relationship would be more profitable in the long term as it is cheaper to retain customers that obtain new ones. In essence Nutrissystem sells a project but Herbalife (HLF) sells a lifestyle.

But, back to the point I’m trying to make. What happens in the kind of marketplace as described in the beginning of the article? The question came to my mind when reading a presentation of a totally unrelated company in a totally unrelated marketplace. KMG Chemicals (KMGB) describe their strategy as such:

“The Company’s acquisition strategy is centered on the lifecycle of chemicals. In the discovery phase, newly patented chemicals generally enjoy high margins and rapid growth. In the generic stage, patents expire, competitors enter, and the market stabilizes. In the consolidation phase, the market begins to shrink, and competitors exit. In the maturity stage, smaller, stable and predictable niche markets exist, and margins often expand. KMG has been successful in acquiring products late in the consolidation phase, and has been able to realize the benefit of increasing margins and cash flows.”

The dietary market is far from being new, but is increasingly being spotted as having lucrative prospective. As a result, Nutrisystem faces competition from all directions, from pharmaceutical companies to lifestyle consultants. In a highly competitive environment margins fall and to hold its competitive position, market participants are forced to reinvest more heavily in its business.

This became very obvious yesterday in Nutrisystems 4Q2010 earnings call. In the word of CEO Joe Reading:

“We believe there are three primary factors impacting our results in January. First was the intense competitive pressure from a major new product launch in the category, the first of its kind in many years from the largest player in the category. Second, dieting consumer was actively seeking deals and bargain shopping. We witnessed this behavior online as we tracked conversion of shopping to buying. And third, our new campaign and offer was ineffective and did not resonate with consumers. Our campaign focused on new frozen foods at a reduced price with one free week.

We had anticipated that this offer would be effective in the peak demand month of January. But the intense competitive environment, coupled with a highly promotional minded consumer was difficult to overcome. As we tested various rate card changes in early January, we found that in fact as we lowered price, we were seeing significant improvement in conversion. While we did have a reduced price point on the newly formatted select frozen product, it was still a $300 price point.

Two things turned the tide; first, as we recognized the need for a much more promotionally driven marketing, we relaunched our rollback price promotion in the third week of January. This effort spiked response, web traffic and call lines back to normalized levels. Second, we saw an immediate improvement in conversion rates across all channels. This resulted in reversing negative year-over-year customer trends, and shifting to strong increases in first-time orders.”

I still feel that the stock market delivered a pretty harsh punishment to the stock as it announced its earnings but shareholders should be very sober about the Nutrisystem´s future profitability. As CFO David Clark stated on the earnings call:

“Now looking to the full year 2010, we generated $509.9 million in revenue; a 2.9% decrease over prior year, gross margin was 55.9%, up from 54% in the prior year reflecting the success of our cost reduction efforts. In fact, this is the highest annual gross margin for the company in its current incarnation.”