RealMoney Silver - Revisiting the NTRI 'Resolution Trade'

Revisiting the NTRI 'Resolution Trade'
By Bill Trent
RealMoney.com Contributor
2/12/2008 10:53 AM EST

Although I was bearish on NutriSystem (NTRI) in October, I thought the stock might offer a trade surrounding a possible "New Year's resolution rally." As the new year began, I offered two potential ways to play the trade:

If we get to, say, Jan. 14 without an announcement, I'd consider that an all-clear signal for the trade.
The actual earnings report will probably come out in early February, along with the guidance for the first quarter that will be so important for the resolution trade. Given the uncertainty around this name, the resolution rally trader probably won't want to hold for more than a few days past the February announcement unless there is some really good news, and even then it might be wise to clear out before the first quarter is reported in April.
Alternatively, I'd consider writing put options. As of the close on Dec. 31, the Feb. 16 ($25) puts were selling at about $2. With the stock at roughly $27, that gives a break-even price of $23 if things go wrong, and an 8% gain in six weeks if things don't go wrong.

The trade, so far, has been one of ups and downs. NutriSystem has lost 4.7% this year (at the time of writing), which at least puts it ahead of the decline in the S&P 500. For the fleet of foot, an ideal exit opportunity came and went in a flash last Monday when the stock surged more than 13% in one day, only to give it all back (and more) over the remainder of the week due to an analyst downgrade over concerns that the current quarter's orders were running below expectations.

The options expire this Saturday and the earnings report is due out next Tuesday. For those who missed last week's opportunity, it is time to revisit the trade and think about exit strategies.

As a result of the volatility, the options expiring this week are trading well above the intrinsic value and probably aren't worth closing out until near the close of trading on Friday. The more adventurous may even want to chance being put the shares in hopes of the company beating estimates or, more important, issuing better-than-expected guidance on Tuesday's call.

For what it's worth, I think the 30-cent earnings estimate for the December quarter is in the bag. If there were to be a significant miss it most likely would have been preannounced. The 92 cents expected for the current quarter is 12 cents below the earnings reported in the first quarter last year, despite an estimated 5% sales increase.

It seems like everything is working against NutriSystem right now. First it was expectations that GlaxoSmithKline's (GSK) over-the-counter weight loss drug Alli could put NutriSystem sales on a diet. After a strong start in June, Alli's sales over the subsequent six months have been weaker.

Meanwhile, the concern over NutriSystem sales has shifted to consumer spending concerns. The expectations of growth in sales but a decline in earnings indicates the company may have expanded its base of telephone representatives (and their related costs) too much, resulting in lower margins.

But that's where I think the NutriSystem story could start to be one of those "bad news is good news" names. For one thing, it is easy to correct having too many telephone reps, since the voluntary turnover among such employees is enormous. For another, the company has been buying back shares and increased its buyback authorization by $100 million, which is (probably not coincidentally) nearly identical to both the amount of cash sitting on the balance sheet at last check and the amount of free cash flow generated during the last year.

Using a nice round $25 share price, a $100 million buyout would reduce the number of shares by 4 million, or nearly 12% of the total number outstanding. Getting the expenses back in line, along with a substantial share count reduction, could go a long way toward spurring earnings growth once again.

So if I had made the resolution trade (which I didn't), I think I would wait things out until after the earnings call. The market is anticipating that lots of things will go wrong, and there are also lots that can go right. But that is a risky play, and I can also understand the motivation to lock in a tax loss and the moral victory of beating the S&P on the trade to date.