This article is a reprint of my February 12, 2007 RealMoney column

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 $2.00. 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. Overall 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 (the 19th). For those that 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 importantly, issuing better than expected guidance on Tuesday’s call.

For what it’s worth, I think the $0.30 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 $0.92 expected for the current quarter is $0.12 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 6 months have been slimmer. 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.

Disclosures: None

This article was originally published at RealMoney on October 4, 2007.

Less than a month after topping Fortune Magazine’s list of the 100 fastest-growing companies, Nutri-System, Inc.’s (NTRI) growth rate came to a screeching halt. The company announced yesterday that while revenue growth will top 20% in the third quarter it will be well below expectations, and earnings per share are expected to be between $0.62 and $0.66 – barely budging from $0.63 last year and well below the $0.82 consensus. With the shares selling off more than 20% in after-hours trading, investors have to figure out whether this stock’s weight loss is permanent or whether, like many of its customers, it could be on a yo-yo.

To start out with, I’m going to lay my cards on the table and admit I didn’t see this coming. I thought investors were being a bit irrational when they sold the shares following a strong earnings report and slightly weak guidance (that has now been revised to really weak.) So when considering anything I say about the name, remember that I have been dead wrong about it to date.

That said, with the after hours sell-off the stock is now trading at just over 10x the trailing 12-month free cash flow. From that multiple, I feel like I can earn an adequate return even if the company doesn’t grow – all it needs to do is maintain its current levels of cash flow.

The problem is, the aforementioned growth has taken the cash flow off the charts. For example, if the growth had been steady I might feel that free cash flow could retract to the $60 million the company posted in 2006, rather than the $108 million it gained in the last half of that year and the first half of 2007. While that would be a sharp cutback, the free cash flow yield would still offer support from which I would hope for growth.

But what if cash flow dropped to 2005 levels? It is surely possible that Nutri-system, a company more than 30 years old, could drop back to the levels seen two years ago, is it not? Well, if it is possible it would be a big problem. In 2005 Nutri-System’s free cash flow was only $12 million. Next to nothing. And I don’t even want to think about 2004.

So, from my point of view Nutri-System doesn’t qualify as a sound investment opportunity right now, despite an apparently cheap valuation. It might, however, be worth a trade.

One guy who did get this story right was Citigroup’s Gregory Badishkanian, who warned last month that sales may suffer in the short term as dieters try out GlaxoSmithKline’s (GSK) new over the counter weight loss drug Alli. He also noted that the comparisons to last year’s third quarter are difficult as that is when Dan Marino joined the company as spokesman. And, of course, October is not known as the time to start a diet.

The tough comparisons are likely to continue, but Badishkanian doesn’t expect dieters to enjoy the digestive side-effects of taking Alli for very long. After we gorge ourselves this holiday season, we are likely to make the same New Year’s resolutions we have often made in the past. And in each of the last three years Nutri-System has enjoyed a strong rally from January through April.

Personally I feel like I would benefit more from the product than from the stock at this point. If the shares are still down in late December I may even attempt the seasonal trade, and by the time that is done there may be a little more clarity about the sustainability of free cash flow.

In any case, making the resolution play will require a good deal of resolve for this volatile stock.