Liabilities & Shareholders' Equity
Table of Contents Marketing. We intend to capitalize on the following competitive strengths to grow: Lease allowances utilized for space improvement are recorded as leasehold improvement assets and amortized over the shorter of the economic useful life of the asset or the lease term. Substantially all of the marketing spending in promoted the direct business. Management considers the following accounting estimates to be the most critical in preparing our consolidated financial statements.
Most Recent Annual Report
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We believe this translates into higher customer satisfaction and more profit. Upsell and a la carte sales, including shakes and additional flexible options have continued to grow as more people are adding them to their orders. We provide weight management products and services, including nutritionally balanced weight loss programs sold primarily online and over the telephone and multi-day kits and single items available at select retail locations.
Critical to increasing customer starts is our ability to deploy marketing dollars while maintaining marketing effectiveness. Reactivation revenue increased due to higher volumes building off of recent increases in new customer counts and a higher reactivation rate.
The credit facility provides for interest on borrowings at either a base rate or the London Inter-Bank Offered Rate, in each case plus an applicable margin and is also subject to an unused fee payable quarterly. Substantially all of the marketing spending in promoted the direct business. 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. Table of Contents In addition to the health risks, there are also cultural implications for those who are overweight or obese. Despite the high percentage of overweight or obese individuals in the U. 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 and Jenny Craig, online diet-oriented sites, self-administered products such as the over-the-counter drug Alli and programs such as the South Beach Diet and medically supervised programs. We believe that the principal competitive factors in the weight loss market are: For more than 35 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 24 hours per day, seven days per week, to answer questions and make recommendations to help each customer achieve his or her weight loss goal. 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 bi-weekly. Table of Contents our clients. The Results Kit also offers a customized meal planner, online community access information, a Quick Start Guide and more. We also announced in January that we had agreed to offer our program at Costco Wholesale Corp. Customers redeem the prepaid card online at our website and then the product is shipped to the customer.
Typically, our customers purchase monthly food packages of shelf-stable food containing 28 breakfasts, lunches, dinners and desserts, which they supplement with fresh dairy, fruit, salad, vegetables and low-glycemic carbohydrate items. In certain instances, depending on the promotional offers available, customers can receive more than the typical 28 days of food.
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 stop shipments. 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.
In January , we expanded operations into Canada. Table of Contents Marketing. Marketing is a core competency that drives sales and builds the NutriSystem brand. We have strong expertise in all facets of both offline and online marketing, and utilize degree, integrated marketing to drive profitable revenue from customers in an efficient, effective way.
We believe NutriSystem is one of the leading and most-efficient offline direct response advertisers. We deploy a hybrid of proven brand-equity-building and direct response techniques to increase awareness of our brand, to encourage qualified customers to call or visit our website and to deliver profitable sales. We track response to each advertisement through unique toll-free numbers and URLs.
We deploy a multi-channel campaign, including Internet, television, print, direct mail and telemarketing, to target new customers. Direct mail and telemarketing efforts complement our media advertising to reactivate lapsed customers and to upsell customers already on program. Our online marketing strategy is focused on driving high volume, cost-effective, qualified leads to the website with a focus on increasing both front- and back-end conversion through constant testing and optimization.
The consumer and business media outreach programs accentuate NutriSystem as a leader and innovator in the weight loss category. Our public relations strategically complement offline and online marketing to increase top-of-mind awareness for NutriSystem, as well as to foster positive word-of-mouth, enhancing purchase consideration of our product.
The NutriSystem brand, our marketing and product innovations, as well as celebrities who have lost weight on our program, are regularly featured in top-tier media outlets such as: We typically compensate our spokespersons based on their initial weight loss on our program and maintenance of the weight loss over time.
As a leading ecommerce company and brand, we constantly strive to employ the latest tools and technology in order to drive increased performance of online customer conversion, retention and reactivation. We utilize our ecommerce platform to drive a highly-customizable and personalized user experience, as well as to effectively and efficiently manage day-to-day ecommerce business operations.
In addition, we combine internal resources with external agencies in the development of our website information architecture, user interface and user experience.
In order to optimize the key online business drivers, we continually perform usability testing and are constantly optimizing our website using a variety of sophisticated third-party testing tools. Finally, we measure our online interaction with customers along with broader website performance via web analytics platforms and tools.
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. Table of Contents 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.
We operate an integrated order receipt, billing, picking, shipping and delivery tracking system comprised of proprietary and third party components. Our computer-assisted picking system allows for virtually paperless order picking in all warehouse facilities. We operate an integrated network of distribution facilities of which one is company-owned and four are outsourced. In , we undertook a complete review of our entire supply chain management function which enabled detailed studies on product cost improvements, vendor productivity, warehouse efficiencies and key cost center opportunities.
This effort resulted in improvement in our inventory management and allowed for the reduction of our outsourced distribution facilities. We have entered into a service agreement with our outside fulfillment provider, which provides for storage, handling and other services, pricing and minimum space commitments. There are other outside fulfillment providers that could be utilized if needed and we are continually evaluating the need for secondary fulfillment services.
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 provided customers take receipt of their second order.
If a customer cancels before receipt of a second order or postpones their second order for more than 30 days, the customer will be charged for shipping and the difference in pricing for an Auto-Delivery order versus a non Auto-Delivery order. All of our foods and supplements are currently outsourced from more than 30 manufacturers or vendors. We have entered into supply agreements with many of these food vendors.
The majority of these agreements provide for annual pricing, annual purchase commitments, as well as exclusivity in the production of certain products, with terms of five years or less.
One agreement also provides for certain rebates to us if certain volume thresholds are exceeded. All of these contracts may be terminated by us upon written notice, generally between 30 and days. We anticipate meeting all annual purchase commitments. We have supply arrangements with these two vendors that require us to make certain minimum purchases. Based on our customer data, our typical customer is female, approximately 48 years of age and weighs lbs.
In January , we initiated advertising programs directed toward men. We believe that, on average, our customers want to lose approximately 45 lbs. 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. We believe that these surveys indicate a willingness to refer our program to others and that our customers value the following NutriSystem program attributes: Our ecommerce and community websites, both of which are based primarily on third party software customized to meet our business needs, 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.
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.
We believe the protection of our trademarks, copyrights, patents, domain names, trade dress, and trade secrets is important to our success.
We aggressively protect our intellectual property rights by relying on a combination of watch services and trademark, copyright, patent, trade dress and trade secret laws, and through the domain name dispute resolution system. None of our employees is represented by a labor union, and we consider relations with our employees to be good. Such documents are available as soon as reasonably practicable after electronic filing of the material with the SEC.
The SEC maintains an Internet site, www. Table of Contents Executive Officers of the Company. Redling has served as our President since September , as our Chief Executive officer since May and as member of our Board since April In November , Mr. Redling became Chairman of our Board.
Prior to becoming Chief Executive Officer, Mr. Redling had served as our Chief Operating Officer since September Before joining us, Mr. Redling held a number of executive positions at AOL, Inc. Redling is also a director of a private company. Prior to joining us, Mr.
Prior to that, Mr. Clark was Chief Financial Officer of SunCom Wireless Holdings, a publicly traded provider of digital wireless communications services, from its founding in through February and held the additional position of Executive Vice President from through February and Senior Vice President from through Prior to joining us, Ms.
Prior to that Ms. Risks Related to Our Business. Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures and our ability to select the right markets and media in which to advertise.
Our planned marketing expenditures may not result in increased revenue or generate sufficient levels of brand name and program awareness. We may not be able to manage our marketing expenditures on a cost-effective basis whereby our customer acquisition cost may exceed the contribution profit generated from each additional customer.
Our sales can be adversely impacted by the health and stability of the general economy. Unfavorable changes in general economic conditions, such as a recession or prolonged economic slowdown, may reduce the demand for our products and otherwise adversely affect our sales. We rely on third parties to provide us with adequate food supply and certain fulfillment, Internet, networking and call center services, the loss of any of which could cause our revenue, earnings or reputation to suffer.
We rely solely on third-party manufacturers to supply all of the food and other products we sell. Table of Contents Freight and Fulfillment. Any replacement fulfillment provider would also require startup time, which could cause us to lose sales and market share. Internet, Networking and Call Centers. Our business also depends on a number of third parties for Internet access, networking and call center services, and we have limited control over these third parties.
Should our network connections go down, our ability to fulfill orders would be delayed. Further, if our website or call centers become unavailable for a noticeable period of time due to Internet or communication failures, our business could be adversely affected, including harm to our brand and loss of sales.
Therefore, we are dependent on maintaining good relationships with these third parties. The services we require from these parties may be disrupted by a number of factors associated with their businesses, including the following: For , we have a one-year contractual agreement with QVC with an automatic extension unless either party decides not to extend the agreement and a minimum level of sales has not been achieved for the year.
Under the QVC agreement, QVC controls when and how often our products and services are offered on-air, and we are not guaranteed any minimum level of sales or transactions. QVC has the exclusive right in the United States, its possessions and territories, the United Kingdom and Germany to promote our products using home shopping television programs other than our own infomercials during the contract term and on a non-exclusive basis for two years thereafter.
If QVC elects not to renew the agreement or reduces airtime for promoting our products, our operating profits will suffer and we will be prohibited from selling our products through competitors of QVC for six months after the termination of the agreement. We may be subject to claims that our personnel are unqualified to provide proper weight loss advice.
Some of our counselors for our weight management program do not have extensive training or certification in nutrition, diet or health fields and have only undergone the training they receive from us. We may be subject to claims from our customers alleging that our personnel lack the qualifications necessary to provide proper advice regarding weight loss and related topics.
We may also be subject to claims that our personnel have provided inappropriate advice or have inappropriately referred or failed to refer customers to health care providers for matters other than weight loss. Table of Contents We may be subject to health-related claims from our customers. The weight management industry is highly competitive. If any of our competitors or a new entrant into the market with significant resources pursues a weight management program similar to ours, our business could be significantly affected.
Competition is intense in the weight management industry and we must remain competitive in the areas of program efficacy, price, taste, customer service and brand recognition.
Some of our competitors are significantly larger than we are and have substantially greater resources. Our business could be adversely affected if someone with significant resources decided to imitate our weight management program. For example, if a major supplier of pre-packaged foods decided to enter this market and made a substantial investment of resources in advertising and training diet counselors, our business could be significantly affected. Any increased competition from new entrants into our industry or any increased success by existing competition could result in reductions in our sales or prices, or both, which could have an adverse effect on our business and results of operations.
New weight loss products or services may put us at a competitive disadvantage. If we pursue competitive advertising, we may be subject to litigation from our competitors.
If we pursue competitive advertising, our competitors may pursue litigation regardless of its merit and chances of success. Our business is subject to online security risks, including security breaches and identity theft.
To succeed, online commerce and communications must provide a secure transmission of confidential information over public networks. Currently, a significant number of our customers authorize us to bill their credit cards directly for all fees charged by us. We rely on third party software products to secure our credit card transactions. Although we have developed systems and processes that are designed to protect consumer information and prevent fraudulent payment transactions and other security breaches, failure to prevent or mitigate such fraud or breaches may adversely affect our operating results.
Table of Contents We may experience fluctuations in our operating results which may cause our stock price to be volatile.
In view of the rapidly evolving nature of our business and the seasonality inherent in the weight loss industry, our operating results may fluctuate significantly. These fluctuations, as well as general economic and market conditions, may adversely affect the market price of our common stock and cause it to fluctuate significantly. Expansion into international markets may expose us to economic, political and social risks in the countries in which we operate.
In January , we expanded operations into Canada and expect to enter Japan, through a partner, by the end of This expansion may be costly as we will be required to divert management time and resources and it could require us to adapt our program to conform to local cultures. We may not be successful in expanding into particular international markets and this expansion could expose our financial results to additional risks in the countries in which we operate.
Financial results could be adversely affected by changes in foreign currency rates, changes in worldwide economic conditions, changes in trade policies or tariffs and political unrest. Future acquisitions and the pursuit of new business opportunities present risks, and we may be unable to achieve the financial and strategic goals of any acquisition or new business. A component of our growth strategy may be to acquire existing businesses or pursue other business opportunities in the market for weight management and fitness products and services.
Even if we succeed in acquiring or building such businesses, we will face a number of risks and uncertainties, including: Table of Contents If we do not continue to receive referrals from existing customers, our customer acquisition cost may increase. We rely on word-of-mouth advertising for a portion of our new customers. If our brand suffers or the number of customers acquired through referrals drops due to other circumstances, our costs associated with acquiring new customers and generating revenue will increase, which will, in turn, have an adverse affect on our profitability.
If we cannot protect and enforce our trademarks and other intellectual property rights, our brand and our business will suffer. We believe that our trademarks and other proprietary rights are important to our success and competitive position. The actions we take to establish and protect our trademarks and other proprietary rights may prove to be inadequate to prevent imitation of our products or services or to prevent others from claiming violations of their trademarks and proprietary rights by us.
In addition, others may develop similar trademarks or other intellectual property independently or assert rights in our trademarks and other proprietary rights. If so, third parties may seek to block or limit sales of our products and services based on allegations that use of some of our marks or other intellectual property constitutes a violation of their intellectual property rights. If we cannot protect our trademarks and other intellectual property rights, or if our trademarks or other intellectual property rights infringe upon the rights of third parties, the value of our brand may decline, which would adversely affect our results of operations.
We are dependent on our key executive officers for future success. Our future success depends to a significant degree on the skills, experience and efforts of our key executive officers.
The loss of the services of any of these individuals could harm our business. We have not obtained life insurance on any key executive officers. If any key executive officers left us or were seriously injured and became unable to work, the business could be harmed. Provisions in our certificate of incorporation may deter or delay an acquisition of us or prevent a change in control, even if an acquisition or a change of control would be beneficial to our stockholders.
Provisions of our certificate of incorporation as amended may have the effect of deterring unsolicited takeovers or delaying or preventing a third party from acquiring control of us, even if our stockholders might otherwise receive a premium for their shares over then current market prices.
In addition, these provisions may limit the ability of stockholders to approve transactions that they may deem to be in their best interests. Our certificate of incorporation as amended permits our Board of Directors to issue preferred stock without stockholder approval upon such terms as the Board of Directors may determine. The rights of the holders of our common stock will be junior to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future.
The issuance of preferred stock could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a majority of our outstanding common stock. The issuance of a substantial number of preferred shares could adversely affect the price of our common stock.
Changes in consumer preferences could negatively impact our operating results. Our program features pre-packaged food selections, which we believe offer convenience and value to our customers. Our continued success depends, to a large degree, upon the continued popularity of our program versus various other weight loss, weight management and fitness regimens, such as low carbohydrate diets, appetite suppressants and diets featured in the published media.
Changes in consumer tastes and preferences away from our pre-packaged food and support and counseling services, and any failure to provide innovative responses to these changes, may have a materially adverse impact on our business, financial condition, operating results, cash flows and prospects. The weight loss industry is subject to adverse publicity, which could harm our business. The weight loss industry receives adverse publicity from time to time, and the occurrence of such publicity could harm us, even if the adverse publicity is not directly related to us.
In the early s, our predecessor businesses were subject to extremely damaging adverse publicity relating to a large number of lawsuits alleging that the NutriSystem weight loss program in use at that time led to gall bladder disease. This publicity was a factor that contributed to the bankruptcy of our predecessor businesses in The significant decline in business resulting from the fen-phen problems caused our predecessor businesses to close all of their company-owned weight loss centers.
Our industry is subject to governmental regulation that could increase in severity and hurt results of operations. Other aspects of our industry are also subject to government regulation. If federal, state, local or foreign regulation of our industry increases for any reason, then we may be required to incur significant expenses, as well as modify our operations to comply with.
Table of Contents new regulatory requirements, which could harm our operating results. Additionally, remedies available in any potential administrative or regulatory actions may include requiring us to refund amounts paid by all affected customers or pay other damages, which could be substantial.
The sale of ingested products involves product liability and other risks. Like other distributors of products that are ingested, we face an inherent risk of exposure to product liability claims if the use of our products results in illness or injury. The foods that we resell in the U.
Product liability claims could have a material adverse effect on our business as we do not have contractual indemnification rights against our other suppliers, and our other remedies against third parties and our existing insurance coverage may not be adequate. Distributors of weight loss food products, vitamins, nutritional supplements and minerals, including our predecessor businesses, have been named as defendants in product liability lawsuits from time to time. The successful assertion or settlement of an uninsured claim, a significant number of insured claims or a claim exceeding the limits of our insurance coverage would harm us by adding costs to the business and by diverting the attention of senior management from the operation of the business.
We may also be subject to claims that our products contain contaminants, are improperly labeled, include inadequate instructions as to use or inadequate warnings covering interactions with other substances. Product liability litigation, even if not meritorious, is very expensive and could also entail adverse publicity for us and reduce our revenue. In addition, the products we distribute, or certain components of those products, may be subject to product recalls or other deficiencies.
Any negative publicity associated with these actions would adversely affect our brand and may result in decreased subscriptions and product sales and, as a result, lower revenues and profits.
We currently lease three locations in Horsham, Pennsylvania. One lease in Horsham expires in , the second in and the third in In November , a fourth lease in Horsham, Pennsylvania commenced with approximately 51, square feet of office space which we do not yet occupy. This lease expires in We have no lease obligations to any of our outsourced fulfillment providers; however, we are subject to minimum space commitments which we may reduce over a specified period of time.
Management believes the Horsham facilities, combined with the outsourced fulfillment capacity, are adequate to meet our needs for the foreseeable future. These actions were consolidated in December under docket number The Company believes the claims are without merit and intends to defend the litigation vigorously.
The Company received in November correspondence from an attorney purporting to represent a NutriSystem shareholder. Following receipt of additional correspondence from the same attorney in February , the Board of Directors was considering its response when the shareholder represented by this attorney commenced a derivative lawsuit in the Court of Common Pleas in the name of the Company against the entire Board of Directors at that time and certain current and former officers.
The parties have reached an agreement to stay this matter pending the disposition of the anticipated motion to dismiss the federal securities putative class action complaint. The Company believes that the claims are without merit and intends to defend the litigation vigorously.
The complaint purported to bring claims on behalf of a class of current and former sales representatives who were compensated by NutriSystem pursuant to a commission-based compensation plan, rather than on an hourly basis. Including Plaintiff, fifty-four former sales representatives and fourteen current sales representatives have opted-into this litigation.
The Company is also involved in other various claims and routine litigation matters. Prior to , we had not declared or paid any dividend since inception. Selected Consolidated Financial Data. Statement of Operations Data: Operating income from continuing operations.
Equity and impairment loss. Basic income per common share: Diluted income per common share: Weighted average shares outstanding: Cash, cash equivalents and marketable securities. Our actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements. The following discussion should be read in conjunction with the financial information included elsewhere in this Annual Report on Form K.
We provide weight management products and services. Our pre-packaged foods are sold to weight loss program participants directly primarily via the Internet and telephone, referred to as the direct channel and through QVC, a television shopping network. In and prior, substantially all of our revenue was generated domestically. Revenue consists primarily of food sales. 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 certain media channels.
New media channels are tested on a continual basis and we consider our media mix to be 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.
While proved to be very challenging from an economic perspective, we continued to focus on expanding our capabilities and strengthening our business. During , we enhanced our ecommerce platform and redesigned our website, entered into the retail channel with our national launch in Costco and extended our business across borders into Canada.
We initiated a concerted effort to improve lifetime customer economics, length of stay and overall customer satisfaction. In the face of weakening new customer demand, it was crucial to improve each and every customer interaction with an eye toward customer success and business profitability, and in we have seen marked improvement in the key metrics of customer satisfaction, length of stay and revenue per customer.
We enhanced the customer experience with newly designed packaging, on-boarding efforts and customer service. We initiated new standards for order fulfillment and new operating procedures that delivered significant improvements in our overall order accuracy, which, we believe is a key driver of future customer satisfaction and re-order rates. In the face of increased food costs and margin pressure, we undertook a complete review of our entire supply chain management function.
That comprehensive review entailed detailed studies on product cost improvements, vendor productivity, warehouse efficiencies and key cost center opportunities. The results contributed to a reduction in overall product costs, delivery costs and packaging costs.
This effort also resulted in improvement in our inventory management as we proceeded to reduce the number of outside distribution centers during Table of Contents We are continuing to see a challenging economic environment in Our key focus in is to continue to leverage our direct-to-consumer model and improve our efficiency.
We have already taken steps to reduce our overall operating costs, improve gross margins and limit capital spending to optimize cash generation in Our consolidated financial statements are prepared in accordance with U.
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.
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. 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.
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax bases and operating loss and tax credit carryforwards.
Deferred tax assets are evaluated for future realization and reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent earnings and expectations of future taxable income and other relevant factors. Table of Contents 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.
Revenue and expenses consist of the following components: 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 expense includes media, advertising production, marketing and promotional expenses and payroll-related expenses for personnel engaged in these activities. 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 and Impairment Loss. Equity and impairment loss consists of our share of the earnings or losses and estimated impairment losses of our equity interests. The investment in Zero Water is accounted for using the equity method of accounting. Interest income, net consists of interest income earned on cash balances and marketable securities, net of interest expense.
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. The decrease in is primarily attributable to the decline in customer starts due to the weakening economy. Revenue is primarily generated through customer starts and the customer ordering behavior, including length of time on our program and the diet program selection.
Critical to increasing customer starts is our ability to deploy marketing dollars while maintaining marketing effectiveness. Factors influencing our marketing effectiveness include the quality of the advertisements, promotional activity by our competitors, as well as the price and availability of appropriate media.
Total costs and expenses. Income from continuing operations before income taxes. Income from continuing operations. The revenue decrease resulted primarily from a decrease in customer starts due to the weakening economy. Gross margin as a percent of revenue decreased to The decrease in gross margin was primarily attributable to increased food and freight costs.
We are continuing to experience pressure on gross margins but are focusing on these costs and are working on a full supply chain optimization effort.