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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the Quarterly Period Ended September 30, 2006

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the Transition Period From  to

Commission File Number 0-28551



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NutriSystem, Inc.

(Exact name of Registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 23-3012204                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|300 Welsh Road, Building 1, Suite 100 Horsham, Pennsylvania    |  | 19044                               
|(Address of principal executive offices)                       |  | (Zip code)                          

(215) 706-5300

(Registrants telephone number, including area code)



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Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2
of the Exchange Act.

Large accelerated filer ̈Accelerated filer  x    Non-accelerated filer ̈

Indicate by check mark whether the registrant is a shell company (as defined by Rule
12b-2 of the Exchange Act).    Yes ̈No  x

Indicate the number of shares outstanding of each of the issuers classes of common stock as of November 2, 2006:



|                              |  |                  
|----------------------------- |  | -----------------
|Common Stock, $.001 par value |  | 35,487,012 shares



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NUTRISYSTEM, INC. AND SUBSIDIARIES

INDEX TO FORM 10-Q



|                                                                                               |  |     
|---------------------------------------------------------------------------------------------- |  | ----
|                                                                                               |  | Page
|PART I - FINANCIAL INFORMATION                                                                 |  |     
|                                                                                               | 
|Item 1 - Financial Statements (unaudited)                                                      |  |     
|                                                                                               | 
|Consolidated Balance Sheets                                                                    |  | 1   
|                                                                                               | 
|Consolidated Statements of Operations                                                          |  | 2   
|                                                                                               | 
|Consolidated Statements of Cash Flows                                                          |  | 3   
|                                                                                               | 
|Notes to Consolidated Financial Statements.                                                    |  | 4   
|                                                                                               | 
|Item 2 
Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 13  
|                                                                                               | 
|Item 3 
Quantitative and Qualitative Disclosure About Market Risk                             |  | 22  
|                                                                                               | 
|Item 4 
Controls and Procedures                                                               |  | 22  
|                                                                                               | 
|PART II -
OTHER INFORMATION                                                                    |  |     
|                                                                                               | 
|Item 1 
Legal Proceedings                                                                     |  | 23  
|                                                                                               | 
|Item 1A 
Risk Factors                                                                         |  | 23  
|                                                                                               | 
|Item 2 
Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 23  
|                                                                                               | 
|Item 3 
Defaults Upon Senior Securities                                                       |  | 23  
|                                                                                               | 
|Item 4 
Submission of Matters to a Vote of Security Holders                                   |  | 23  
|                                                                                               | 
|Item 5 
Other Information                                                                     |  | 23  
|                                                                                               | 
|Item 6 
Exhibits.                                                                             |  | 23  
|                                                                                               | 
|SIGNATURES                                                                                     |  | 24  



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NUTRISYSTEM, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands except share and per share amounts)



|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | ---------------- | - | ------- | -
|                                                                                                                                                                    |  | September 30,2006 |         | December 31,2005 |  
|ASSETS                                                                                                                                                              |  |                   |         |                  |   |         |  
|                                                                                                                                                                    |  |                  
|CURRENT ASSETS:                                                                                                                                                     |  |                   |         |                  |   |         |  
|Cash and cash equivalents                                                                                                                                           |  | $                 | 5,637   |                  | $ | 3,902   |  
|Marketable securities                                                                                                                                               |  |                   | 96,080  |                  |   | 42,066  |  
|Trade receivables                                                                                                                                                   |  |                   | 11,314  |                  |   | 7,517   |  
|Inventories                                                                                                                                                         |  |                   | 26,691  |                  |   | 34,153  |  
|Deferred income taxes                                                                                                                                               |  |                   | 2,786   |                  |   | 1,577   |  
|Other current assets                                                                                                                                                |  |                   | 3,157   |                  |   | 4,281   |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|Total current assets                                                                                                                                                |  |                   | 145,665 |                  |   | 93,496  |  
|                                                                                                                                                                    |  |                  
|FIXED ASSETS, net                                                                                                                                                   |  |                   | 8,670   |                  |   | 6,002   |  
|                                                                                                                                                                    |  |                  
|IDENTIFIABLE INTANGIBLE ASSETS, net                                                                                                                                 |  |                   | 1,215   |                  |   | 1,351   |  
|                                                                                                                                                                    |  |                  
|GOODWILL                                                                                                                                                            |  |                   | 465     |                  |   | 465     |  
|                                                                                                                                                                    |  |                  
|DEFERRED INCOME TAXES                                                                                                                                               |  |                   | 1,017   |                  |   | 5,787   |  
|                                                                                                                                                                    |  |                  
|OTHER ASSETS                                                                                                                                                        |  |                   | 326     |                  |   | 145     |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|                                                                                                                                                                    |  | $                 | 157,358 |                  | $ | 107,246 |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                |  |                   |         |                  |   |         |  
|                                                                                                                                                                    |  |                  
|CURRENT LIABILITIES:                                                                                                                                                |  |                   |         |                  |   |         |  
|Current portion of note payable and capital lease obligation                                                                                                        |  | $                 | 178     |                  | $ | 171     |  
|Accounts payable                                                                                                                                                    |  |                   | 30,068  |                  |   | 25,886  |  
|Accrued payroll and related benefits                                                                                                                                |  |                   | 4,743   |                  |   | 963     |  
|Accrued income taxes                                                                                                                                                |  |                   | 6,246   |                  |   |        |  
|Other current liabilities                                                                                                                                           |  |                   | 980     |                  |   | 1,006   |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|Total current liabilities                                                                                                                                           |  |                   | 42,215  |                  |   | 28,026  |  
|                                                                                                                                                                    |  |                  
|NON-CURRENT LIABILITIES                                                                                                                                             |  |                   | 425     |                  |   | 254     |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|Total liabilities                                                                                                                                                   |  |                   | 42,640  |                  |   | 28,280  |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|COMMITMENTS AND CONTINGENCIES (Note 6)                                                                                                                              |  |                   |         |                  |   |         |  
|                                                                                                                                                                    |  |                  
|STOCKHOLDERS EQUITY:                                                                                                                                               |  |                   |         |                  |   |         |  
|                                                                                                                                                                    |  |                  
|Preferred stock, $0.001 par value (5,000,000 shares authorized, no shares issued and outstanding)                                                                   |  |                   |        |                  |   |        |  
|Common stock, $0.001 par value (100,000,000 shares authorized; shares issued and outstanding 35,446,228 at September 30, 2006 and
35,432,055 at December 31, 2005) |  |                   | 35      |                  |   | 35      |  
|Additional paid-in capital                                                                                                                                          |  |                   | 49,378  |                  |   | 79,149  |  
|Retained earnings (accumulated deficit)                                                                                                                             |  |                   | 65,305  |                  |   | (218    | )
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|Total stockholders equity                                                                                                                                          |  |                   | 114,718 |                  |   | 78,966  |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  
|                                                                                                                                                                    |  | $                 | 157,358 |                  | $ | 107,246 |  
|                                                                                                                                                                    |  |                   |         |                  |   |         |  

The accompanying notes are an integral part of these consolidated financial statements.



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##### Table of Contents

NUTRISYSTEM, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share amounts)



|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|------------------------------------ |  | -------------------------------- | ------- | ------------------------------- | - | ------ |  | ---- | ------- |  | - | -------
|                                     |  | Three Months Ended September 30, |         | Nine Months Ended September 30,
|                                     |  | 2006                             |         | 2005                            |   | 2006   |  | 2005
|REVENUE                              |  | $                                | 155,258 |                                 | $ | 64,518 |  | $    | 434,640 |  | $ | 142,889
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|COSTS AND EXPENSES:                  |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|Cost of revenue                      |  |                                  | 73,697  |                                 |   | 32,697 |  |      | 210,876 |  |   | 74,021 
|Marketing                            |  |                                  | 34,143  |                                 |   | 14,968 |  |      | 87,829  |  |   | 31,870 
|General and administrative           |  |                                  | 10,025  |                                 |   | 5,506  |  |      | 31,215  |  |   | 12,784 
|Depreciation and amortization        |  |                                  | 715     |                                 |   | 232    |  |      | 1,833   |  |   | 579    
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|Total costs and expenses             |  |                                  | 118,580 |                                 |   | 53,403 |  |      | 331,753 |  |   | 119,254
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|Operating income                     |  |                                  | 36,678  |                                 |   | 11,115 |  |      | 102,887 |  |   | 23,635 
|                                     |  |                                  |         |                                
|INTEREST INCOME, net                 |  |                                  | 1,061   |                                 |   | 330    |  |      | 2,529   |  |   | 390    
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|Income before income taxes           |  |                                  | 37,739  |                                 |   | 11,445 |  |      | 105,416 |  |   | 24,025 
|                                     |  |                                  |         |                                
|INCOME TAXES                         |  |                                  | 14,341  |                                 |   | 4,250  |  |      | 39,893  |  |   | 9,282  
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|Net income                           |  | $                                | 23,398  |                                 | $ | 7,195  |  | $    | 65,523  |  | $ | 14,743 
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|BASIC INCOME PER SHARE               |  | $                                | 0.65    |                                 | $ | 0.21   |  | $    | 1.83    |  | $ | 0.46   
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|DILUTED INCOME PER SHARE             |  | $                                | 0.63    |                                 | $ | 0.19   |  | $    | 1.76    |  | $ | 0.42   
|                                     |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|WEIGHTED AVERAGE SHARES OUTSTANDING: |  |                                  |         |                                 |   |        |  |      |         |  |   |        
|Basic                                |  |                                  | 35,833  |                                 |   | 34,309 |  |      | 35,855  |  |   | 32,196 
|                                     |  |                                  |         |                                
|Diluted                              |  |                                  | 37,117  |                                 |   | 36,957 |  |      | 37,239  |  |   | 35,045 

The accompanying notes are an integral part of these consolidated financial statements.



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NUTRISYSTEM, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)



|                                                                                  |  |                                |          |   |      |   |         |  
|--------------------------------------------------------------------------------- |  | ------------------------------ | -------- | - | ---- | - | ------- | -
|                                                                                  |  | Nine Months EndedSeptember 30, |         
|                                                                                  |  | 2006                           |          |   | 2005 |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                             |  |                                |          |   |      |   |         |  
|Net income                                                                        |  | $                              | 65,523   |   |      | $ | 14,743  |  
|Adjustments to reconcile net income to net cash provided by operating activities- |  |                                |          |   |      |   |         |  
|Depreciation and amortization                                                     |  |                                | 1,833    |   |      |   | 579     |  
|Accrued interest income                                                           |  |                                | (614     | ) |      |   | (296    | )
|Imputed interest expense                                                          |  |                                | 11       |   |      |   | 15      |  
|Loss on disposal of fixed assets                                                  |  |                                | 4        |   |      |   | 8       |  
|Share-based expense                                                               |  |                                | 4,625    |   |      |   | 109     |  
|Deferred tax expense                                                              |  |                                | 3,561    |   |      |   | 2,652   |  
|Tax benefit from stock option exercises                                           |  |                                |         |   |      |   | 3,518   |  
|Changes in operating assets and liabilities-                                      |  |                                |          |   |      |   |         |  
|Trade receivables                                                                 |  |                                | (3,797   | ) |      |   | (5,297  | )
|Inventories                                                                       |  |                                | 7,462    |   |      |   | (7,962  | )
|Other assets                                                                      |  |                                | 943      |   |      |   | (197    | )
|Accounts payable                                                                  |  |                                | 4,182    |   |      |   | 12,317  |  
|Accrued payroll and related benefits                                              |  |                                | 3,780    |   |      |   | 2,496   |  
|Accrued income taxes                                                              |  |                                | 6,246    |   |      |   | 2,747   |  
|Other liabilities                                                                 |  |                                | (327     | ) |      |   | (170    | )
|                                                                                  |  |                                |          |   |      |   |         |  
|Net cash provided by operating activities                                         |  |                                | 93,432   |   |      |   | 25,262  |  
|                                                                                  |  |                                |          |   |      |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                             |  |                                |          |   |      |   |         |  
|Purchases of marketable securities                                                |  |                                | (102,000 | ) |      |   | (45,150 | )
|Sales of marketable securities                                                    |  |                                | 48,600   |   |      |   |        |  
|Capital additions                                                                 |  |                                | (4,396   | ) |      |   | (2,251  | )
|                                                                                  |  |                                |          |   |      |   |         |  
|Net cash used in investing activities                                             |  |                                | (57,796  | ) |      |   | (47,401 | )
|                                                                                  |  |                                |          |   |      |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                             |  |                                |          |   |      |   |         |  
|Issuance of common shares                                                         |  |                                |         |   |      |   | 25,399  |  
|Purchase of common shares                                                         |  |                                | (45,368  | ) |      |   |        |  
|Tax benefit from stock option exercises                                           |  |                                | 8,756    |   |      |   |        |  
|Exercise of stock options                                                         |  |                                | 2,711    |   |      |   | 1,762   |  
|                                                                                  |  |                                |          |   |      |   |         |  
|Net cash (used in) provided by financing activities                               |  |                                | (33,901  | ) |      |   | 27,161  |  
|                                                                                  |  |                                |          |   |      |   |         |  
|NET CHANGE IN CASH AND CASH EQUIVALENTS                                           |  |                                | 1,735    |   |      |   | 5,022   |  
|                                                                                  |  |                               
|CASH AND CASH EQUIVALENTS, beginning of period                                    |  |                                | 3,902    |   |      |   | 4,201   |  
|                                                                                  |  |                                |          |   |      |   |         |  
|CASH AND CASH EQUIVALENTS, end of period                                          |  | $                              | 5,637    |   |      | $ | 9,223   |  
|                                                                                  |  |                                |          |   |      |   |         |  

The accompanying notes are an integral part of these consolidated financial statements.



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NUTRISYSTEM, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited, in thousands except share and per share amounts)

1. BACKGROUND

Nature of the Business

NutriSystem, Inc. (the Company or NutriSystem) provides weight management and fitness products and services. The Companys 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. NutriSystem also owns Slim and Tone LLC (Slim and Tone), a franchisor of womens express fitness centers. Slim and Tone franchisees sell NutriSystems diet program in their centers as commissioned
representatives. Substantially all of the Companys revenue is generated domestically.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Presentation of Financial Statements

The
Companys consolidated financial statements include the accounts of NutriSystem, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Interim Financial Statements

The Companys consolidated
financial statements as of September 30, 2006 and for the three and nine months ended September 30, 2006 and 2005 are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments)
necessary for a fair presentation of the Companys financial position and results of operations for these interim periods. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of
the results to be expected for the year ending December 31, 2006.

Cash, Cash Equivalents and Marketable Securities

Cash and cash equivalents include only securities having a maturity of three months or less at the time of purchase. At September 30, 2006 and December 31,
2005, cash demand accounts and money market accounts comprised all of the Companys cash and cash equivalents.

Marketable securities consist of
corporate auction-rate securities with original maturities of greater than three months. As of September 30, 2006, all of the auction-rate securities held have maturities in excess of 10 years. The Companys investment policy permits
investments in auction-rate securities that have interest reset dates of three months or less at the time of purchase. The reset date is the date in which the underlying interest rate is revised based on a Dutch auction and the underlying security
may be readily sold. Although the securities held have extended maturities, the Company classifies these securities as a current asset as the investments are considered to be available-for-sale securities.



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The following summarizes cash, cash equivalents and marketable securities:



|                          |  |      |        |                 |   |           |  |   |       
|------------------------- |  | ---- | ------ | --------------- | - | --------- |  | - | ------
|                          |  | Cost |        | AccruedInterest |   | FairValue
|Cash and cash equivalents |  |      |        |                 |   |           |  |   |       
|                          |  |      |       
|Cash demand deposits      |  | $    | 5,196  |                 | $ |          |  | $ | 5,196 
|Money market accounts     |  |      | 441    |                 |   |          |  |   | 441   
|                          |  |      |        |                 |   |           |  |   |       
|September 30, 2006        |  | $    | 5,637  |                 | $ |          |  | $ | 5,637 
|                          |  |      |        |                 |   |           |  |   |       
|Marketable securities     |  |      |        |                 |   |           |  |   |       
|                          |  |      |       
|Auction-rate securities   |  | $    | 95,200 |                 | $ | 880       |  | $ | 96,080
|                          |  |      |        |                 |   |           |  |   |       
|September 30, 2006        |  | $    | 95,200 |                 | $ | 880       |  | $ | 96,080
|                          |  |      |        |                 |   |           |  |   |       
|Cash and cash equivalents |  |      |        |                 |   |           |  |   |       
|                          |  |      |       
|Cash demand deposits      |  | $    | 3,621  |                 | $ |          |  | $ | 3,621 
|Money market accounts     |  |      | 281    |                 |   |          |  |   | 281   
|                          |  |      |        |                 |   |           |  |   |       
|December 31, 2005         |  | $    | 3,902  |                 | $ |          |  | $ | 3,902 
|                          |  |      |        |                 |   |           |  |   |       
|Marketable securities     |  |      |        |                 |   |           |  |   |       
|                          |  |      |       
|Auction-rate securities   |  | $    | 41,800 |                 | $ | 266       |  | $ | 42,066
|                          |  |      |        |                 |   |           |  |   |       
|December 31, 2005         |  | $    | 41,800 |                 | $ | 266       |  | $ | 42,066
|                          |  |      |        |                 |   |           |  |   |       

As of September 30, 2006 and December 31, 2005, auction rate securities consist of variable interest
bonds of higher education institutions.

Dependence on Key Customer / Suppliers

Approximately 6% and 9% of the Companys revenue for the nine months ended September 30, 2006 and 2005, respectively, relates to sales through QVC. Accounts receivable from QVC at September 30, 2006 and
December 31, 2005 were $2,201 and $410, respectively.

Approximately 34%, 13% and 12% of inventory purchases for the nine months ended
September 30, 2006 were from the largest three suppliers. The Company has a supply arrangement with one of these vendors that requires the Company to make minimum purchases (see Note 6). For the nine months ended September 30, 2005, these
vendors supplied 37%, 11% and 15% of total inventory purchases.

In the nine months ended September 30, 2006 and 2005, the Company outsourced
approximately 87% and 72% of its fulfillment operations to a third-party provider.

Inventories

Inventories consist principally of packaged food held in the Companys warehouse or in outside fulfillment locations. Inventories are valued at the lower of cost or
market, with cost determined using the first-in, first-out (FIFO) method.



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Fixed Assets

Fixed
assets are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the related assets, which are generally two to seven years. Leasehold improvements are amortized on a straight-line basis over the
lesser of the estimated useful life of the asset or the related lease term. Capital leases are amortized on a straight-line basis over the respective lease terms. Expenditures for repairs and maintenance are charged to expense as incurred, while
major renewals and improvements are capitalized.

Identifiable Intangible Assets and Goodwill

Identifiable intangible assets and goodwill arose from the acquisition of Slim and Tone in December 2004. Identifiable intangible assets represent trade names and
trademarks, customer relationships, procedural manuals and covenants not to compete acquired in the transaction. Goodwill represents the excess of the purchase price over the net tangible and identifiable intangible assets acquired of Slim and Tone.
The Company does not amortize trade names, trademarks and goodwill due to their indefinite life, but management reviews these assets at least annually for impairment. The other identifiable intangible assets are presented at cost, net of accumulated
amortization, and are amortized over their estimated useful lives.

Valuation of Long-Lived Assets

The Company continually evaluates whether events or circumstances have occurred that indicate that the remaining useful lives of its long-lived assets, primarily fixed
assets and purchased identifiable intangibles subject to amortization should be revised or that the remaining balance of such assets may not be recoverable using objective methodologies. Such methodologies include evaluations based on the
undiscounted cash flows generated by the underlying assets or other determinants of fair value. As of September 30, 2006 and December 31, 2005, respectively, management believes that no reductions to the remaining useful lives or
write-downs of long-lived assets are required.

Revenue Recognition

Revenue from product sales is recognized when the earnings process is complete, which is upon transfer of title to the product. This transfer occurs upon shipment. Recognition of revenue upon shipment meets the
revenue recognition criteria in that persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed and determinable and collection is reasonably assured. Customers may return unopened product within 30 days of
purchase in order to receive a refund or credit. Estimated returns are accrued at the time the sale is recognized and actual returns are tracked monthly and the estimated returns reserve is adjusted quarterly.

Revenues from product sales include amounts billed for shipping and handling, and are presented net of returns and free food products provided to consumers. Revenues
from shipping and handling charges were $1,963 and $818 for the nine months ended September 30, 2006 and 2005, respectively.

Revenues for Slim and
Tone consist primarily of franchise fees, food sales and royalties. Revenues for franchise fees are recognized when a franchise center opens for business. Slim and Tone franchise fee payments received prior to a franchise center opening are recorded
as deferred revenue. Royalties are paid monthly and recognized in the month the royalty is earned.

Marketing Expense

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 direct mailing 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. Typically, this period falls within 40 days of the initial direct mailing. All other advertising costs are charged to expense as incurred. At
September 30, 2006 and December 31, 2005, $509 and $137, respectively, of capitalized direct-mail advertising costs are included in other current assets and $1,212 and $1,027 of costs have been prepaid for upcoming advertisements and
promotions. Media expense was $83,153 and $29,102 during the nine months ended September 30, 2006 and 2005, respectively.



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Income Taxes

Income
taxes are accounted for under the asset and liability method. 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 and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences
are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the consolidated statement of operations in the period that includes the enactment date.

Fair Value of Financial Instruments

The carrying values of the
Companys financial instruments, including cash, cash equivalents, marketable securities, trade receivables and accounts payable, approximate the fair values due to the short-term nature of these instruments. The carrying amount of the note
payable approximates the fair value.

Net Income Per Common Share

Basic earnings per share (EPS) is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution from the exercise
or conversion of securities into common stock, such as stock options and warrants. The following table sets forth the computation of basic and diluted earnings per share:



|                                              |  |                                          |        |                                |   |        |  |      |        |  |   |       
|--------------------------------------------- |  | ---------------------------------------- | ------ | ------------------------------ | - | ------ |  | ---- | ------ |  | - | ------
|                                              |  | Three Months EndedSeptember 30,          |        | Nine Months EndedSeptember 30,
|                                              |  | 2006                                     |        | 2005                           |   | 2006   |  | 2005
|                                              |  | (in thousands, except per share amounts)
|Net income:                                   |  | $                                        | 23,398 |                                | $ | 7,195  |  | $    | 65,523 |  | $ | 14,743
|                                              |  |                                          |        |                                |   |        |  |      |        |  |   |       
|Weighted average shares outstanding:          |  |                                          |        |                                |   |        |  |      |        |  |   |       
|Basic                                         |  |                                          | 35,833 |                                |   | 34,309 |  |      | 35,855 |  |   | 32,196
|Effect of dilutive stock options (net of tax) |  |                                          | 1,284  |                                |   | 2,648  |  |      | 1,384  |  |   | 2,849 
|                                              |  |                                          |        |                                |   |        |  |      |        |  |   |       
|Diluted                                       |  |                                          | 37,117 |                                |   | 36,957 |  |      | 37,239 |  |   | 35,045
|                                              |  |                                          |        |                                |   |        |  |      |        |  |   |       
|Earnings per common share:                    |  |                                          |        |                                |   |        |  |      |        |  |   |       
|Basic                                         |  | $                                        | 0.65   |                                | $ | 0.21   |  | $    | 1.83   |  | $ | 0.46  
|                                              |  |                                          |        |                                |   |        |  |      |        |  |   |       
|Diluted                                       |  | $                                        | 0.63   |                                | $ | 0.19   |  | $    | 1.76   |  | $ | 0.42  
|                                              |  |                                          |        |                                |   |        |  |      |        |  |   |       

The common stock equivalents excluded from weighted average shares outstanding for diluted net income per share
purposes because the effect would be anti-dilutive were common stock equivalents representing 3,000 and 83,975 shares of common stock for the three and nine months ended September 30, 2006 and 92,900 and 125,633 shares of common stock for the
three and nine months ended September 30, 2005, respectively.

Share-Based Payment Awards

Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment, addresses all forms of share-based payment awards,
including shares issued under employee stock purchase plans, stock options, restricted stock and stock appreciation rights. It requires companies to recognize in the statement of operations the grant-date fair value of stock options and other
equity-based compensation issued to employees. The statement eliminates the intrinsic value-based method prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations, that the Company used prior to 2006. The Company adopted SFAS No. 123R effective January 1, 2006 using the modified prospective method (see Note 4).

The fair-value of share-based awards is determined using the Black-Scholes valuation model, which is the same model the Company used previously for valuing share-based
awards for footnote disclosures purposes.



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##### Table of Contents

The fair-value of share-based awards is recognized over the requisite service period, net of estimated forfeitures. The
Company relies primarily upon historical experience to estimate expected forfeitures and recognizes compensation expense on a straight-line basis from the date of grant. The Company issues new shares upon exercise of stock options.

Certain of the Companys share-based payment arrangements are outside the scope of SFAS No. 123R and are subject to Emerging Issues Task Force
(EITF) Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Companys Own Stock, as these stock options are held by certain non-employee consultants. The fair value
of these vested and unexercised awards was estimated using the Black-Scholes option pricing model and was reclassified from equity to a current liability as of January 1, 2006. The fair values of these awards are remeasured at each financial
statement date until the awards are settled or expire.

Cash Flow Information

The Company made payments for income taxes of $21,000 and $307 and minimal payments for interest during the nine months ended September 30, 2006 and 2005, respectively.

Recently Issued Accounting Pronouncements

In September 2006, the
Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value
measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for
interim periods within those fiscal years. The Company is currently evaluating whether the adoption of SFAS No. 157 will have an impact on the Companys financial position and results of operations.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 108, Quantifying
Misstatements. SAB 108 provides interpretative guidance on how public companies quantify financial statement misstatements. There have been two common approaches used to quantify such errors. Under an income statement approach, the
roll-over method, the error is quantified as the amount by which the current year income statement is misstated. Alternatively, under a balance sheet approach, the iron curtain method, the error is quantified as the
cumulative amount by which the current year balance sheet is misstated. In SAB 108, the SEC established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the
companys financial statements and the related financial statement disclosures. This model is commonly referred to as a dual approach because it requires quantification of errors under both the roll-over and iron curtain methods.
SAB 108 is effective for the first fiscal year ending after November 15, 2006. The adoption of SAB 108 is not expected to have a material impact on the Companys financial position and results of operations.

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement
No. 109 (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides
guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating whether
the adoption of FIN 48 will have an impact on the Companys financial position and results of operations.

In June 2006, the FASB ratified a tentative
conclusion on EITF Issue 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation). The EITF conclusion requires companies to
disclose whether reported revenues include any government-imposed sales or value added taxes. The Company will adopt this conclusion in its consolidated financial statements for the fiscal year ending December 31, 2006 and will include in its
significant accounting policy disclosures a statement that revenues are reported on a net basis, excluding any sales or value added taxes.

Use of
Estimates

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and operating expenses during the reporting period. Actual results could differ from
these estimates.



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##### Table of Contents

3. CAPITAL STOCK

Common Stock

The Company issued 903,252 and 1,828,856 shares of common stock in the nine months ended September 30, 2006 and 2005,
respectively, upon the exercise of common stock options and received proceeds of $2,711 and $1,762. Also, in the nine months ended September 30, 2006 and 2005, respectively, the Company issued 7,621 and 36,500 shares of common stock as
compensation to board members, certain consultants and spokespersons per their contracts. Costs recognized for these stock grants were $350 and $109 for the respective periods. In June 2005, the Company completed a secondary public offering of
2,476,625 shares of common stock and received net proceeds of $25,399.

On August 1, 2006, the Company announced that its Board of Directors
authorized the repurchase of up to $50,000 of its outstanding shares of common stock. The stock repurchase program does not have an expiration date and may be limited or terminated at any time without prior notice. The timing and actual number of
shares repurchased depend on a variety of factors including price, corporate and regulatory requirements, alternative investment opportunities and other market conditions. In August and September 2006, the Company purchased and subsequently retired
896,700 shares of common stock for an aggregate cost of $45,368.

Preferred Stock

The Company has authorized 5,000,000 shares of preferred stock issuable in series upon resolution of the Board of Directors. Unless otherwise required by law, the Board of Directors can, without stockholder approval,
issue preferred stock in the future with voting and conversion rights that could adversely affect the voting power of the common stock. The issuance of preferred stock may have the effect of delaying, averting or preventing a change in control of
the Company.

4. SHARE-BASED EXPENSE

The Company has
two employee incentive plans, the 1999 Equity Incentive Plan and 2000 Equity Incentive Plan. Under these plans, a variety of equity investments can be offered to key employees, including incentive and nonqualified stock options to purchase shares of
the Companys common stock and stock awards. The 1999 Equity Incentive Plan and the 2000 Equity Incentive Plan authorize up to 1,000,000 and 5,600,000 shares of common stock, respectively, for issuance.

In June 2000, the Company also adopted the 2000 Equity Incentive Plan for Outside Directors and Consultants (the Director Plan) under which a variety of
equity investments are offered to non-employee directors and consultants to the Company, including nonqualified stock options to purchase shares of the Companys common stock or stock awards. The Director Plan authorizes up to 1,500,000 shares
of common stock for issuance.

Under each of the plans, the Board of Directors determines the term of each award, but no award can be exercisable more than
10 years from the date the award is granted. To date, all of the awards issued under the Equity Incentive Plans expire 10 years from the issue date and all of the awards issued under the Director Plan expire between three months and 10 years from
the issue date. The Board also determines vesting provisions and the exercise price per share, which is the fair market value at date of grant. Awards issued to employees generally vest over a three year period.

The following table summarizes the options granted, exercised and cancelled during the nine months ended September 30, 2006:



|                                  |  |                 |   |  |                                |       |                                                  |      |                          |   |        
|--------------------------------- |  | --------------- | - |  | ------------------------------ | ----- | ------------------------------------------------ | ---- | ------------------------ | - | -------
|                                  |  | Number ofShares |   |  | Weighted-AverageExercise Price |       | Weighted-AverageRemainingContractualLife (years) |      | AggregateIntrinsic Value
|Outstanding, December 31, 2005    |  | 2,732,837       |   |  | $                              | 3.55  |                                                  |      |                          |   |        
|Granted                           |  |                |   |  |                                |      |                                                  |      |                          |   |        
|Exercised                         |  | (903,252        | ) |  |                                | 3.00  |                                                  |      |                          |   |        
|Forfeited                         |  | (43,334         | ) |  |                                | 15.25 |                                                  |      |                          |   |        
|Expired                           |  |                |   |  |                                |      |                                                  |      |                          |   |        
|                                  |  |                 |   |  |                                |       |                                                  |      |                          |   |        
|Outstanding, September 30, 2006   |  | 1,786,251       |   |  | $                              | 3.55  |                                                  | 7.61 |                          | $ | 104,924
|                                  |  |                 |   |  |                                |       |                                                  |      |                          |   |        
|Exercisable at September 30, 2006 |  | 701,750         |   |  | $                              | 1.37  |                                                  | 6.71 |                          | $ | 42,750 
|                                  |  |                 |   |  |                                |       |                                                  |      |                          |   |        



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##### Table of Contents

The Company adopted SFAS No. 123R, effective January 1, 2006. Prior to January 1, 2006, the Company
applied the intrinsic value method of accounting for all stock-based employee compensation in accordance with APB Opinion No. 25, and related interpretations. The Company elected to use the modified prospective method for adopting SFAS
No. 123R. Under this method, the provisions of SFAS No. 123R apply to all awards granted or modified after the date of adoption. Accordingly, prior periods have not been restated. SFAS 123R also requires the benefits of tax deductions in
excess of recognized compensation expense be recognized as financing cash flows, rather than as operating cash flows as prescribed under the prior accounting rules. This requirement reduces net operating cash flows and increases net financing cash
flows in periods after adoption.

For the three and nine months ended September 30, 2006, the Company recorded a pre-tax compensation charge of $513
and $1,841, respectively, on the accompanying consolidated statement of operations for the unvested portion of previously granted stock option awards that remained outstanding on the date of adoption. There were no option grants during the nine
months ended September 30, 2006. The weighted-average fair value of the options issued in the three and nine months ended September 30, 2005 was $17.42 and $9.18, respectively. The total intrinsic value of stock options exercised during
the three and nine months ended September 30, 2006 was $3,652 and $42,085, respectively, and $7,515 and $18,392 for the three and nine months ended September 30, 2005, respectively.

The following table illustrates the effect on the Companys net income and net income per share for the prior period if the Company had recorded compensation
expense for the estimated fair value of stock-based employee compensation under SFAS No. 123:



|                                                                                                                      |  |                                          |       |   |                                     |   |        |  
|--------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ----- | - | ----------------------------------- | - | ------ | -
|                                                                                                                      |  | Three Months Ended September 30, 2005    |       |   | Nine Months EndedSeptember 30, 2005 |  
|                                                                                                                      |  | (in thousands, except per share amounts) |      
|Net income:                                                                                                           |  |                                          |       |  
|As reported                                                                                                           |  | $                                        | 7,195 |   |                                     | $ | 14,743 |  
|Add stock-based employee compensation expense included in reported net income, net of tax                             |  |                                          |      |   |                                     |   |       |  
|Impact of total stock-based compensation expense determined under fair-value based method for all rewards, net of tax |  |                                          | (348  | ) |                                     |   | (845   | )
|                                                                                                                      |  |                                          |       |   |                                     |   |        |  
|Pro forma                                                                                                             |  | $                                        | 6,847 |   |                                     | $ | 13,898 |  
|                                                                                                                      |  |                                          |       |   |                                     |   |        |  
|Basic net income per share:                                                                                           |  |                                          |       |   |                                     |   |        |  
|As reported                                                                                                           |  | $                                        | 0.21  |   |                                     | $ | 0.46   |  
|                                                                                                                      |  |                                          |       |   |                                     |   |        |  
|Pro forma                                                                                                             |  | $                                        | 0.20  |   |                                     | $ | 0.43   |  
|                                                                                                                      |  |                                          |       |   |                                     |   |        |  
|Diluted net income per share:                                                                                         |  |                                          |       |   |                                     |   |        |  
|As reported                                                                                                           |  | $                                        | 0.19  |   |                                     | $ | 0.42   |  
|                                                                                                                      |  |                                          |       |   |                                     |   |        |  
|Pro forma                                                                                                             |  | $                                        | 0.19  |   |                                     | $ | 0.42   |  
|                                                                                                                      |  |                                          |       |   |                                     |   |        |  

In calculating pro forma compensation, the fair value of each stock option is estimated on the date of grant using
the Black-Scholes option pricing model and the following weighted-average assumptions:



|                         |  |                                      |   |  |                                     |  
|------------------------ |  | ------------------------------------ | - |  | ----------------------------------- | -
|                         |  | Three Months EndedSeptember 30,
2005 |   |  | Nine Months EndedSeptember 30,
2005 |  
|Dividend yield           |  | None                                 |   |  | None                                |  
|Expected volatility      |  | 115.6                                | % |  | 117.2                               | %
|Risk-free interest rate  |  | 4.0                                  | % |  | 4.0                                 | %
|Expected life (in years) |  | 5.6                                  |   |  | 5.6                                 |  



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##### Table of Contents

The following table summarizes the restricted stock activity for the nine months ended
September 30, 2006:



|                              |  |                 |  |                                      |      
|----------------------------- |  | --------------- |  | ------------------------------------ | -----
|                              |  | Number ofShares |  | Weighted-AverageGrant-DateFair Value
|Nonvested, December 31, 2005  |  | 28,010          |  | $                                    | 39.28
|Granted                       |  | 19,585          |  |                                      | 49.90
|Vested                        |  |                |  |                                      |     
|Cancelled                     |  |                |  |                                      |     
|                              |  |                 |  |                                      |      
|Nonvested, September 30, 2006 |  | 47,595          |  | $                                    | 43.65
|                              |  |                 |  |                                      |      

The Company recorded compensation of $401 in the accompanying consolidated statement of operations for the nine
months ended September 30, 2006 in connection with the issuance of the restricted shares.

As of September 30, 2006, there was $4,790 of total
unrecognized compensation expense related to unvested share-based compensation arrangements, which is expected to be recognized over a weighted-average period of 1.1 years.

SFAS No. 123R addresses financial instruments issued as part of share-based payment arrangements in exchange for employee services. Certain of the Companys share-based payment arrangements are outside the
scope of SFAS No. 123R and are subject to EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Companys Own Stock, which requires the stock options held by certain
non-employee consultants to be accounted for as liability awards. The fair value of these vested and unexercised awards was estimated using the Black-Scholes option pricing model and $3,223 was reclassified from equity to a current liability as of
January 1, 2006. The fair value of the award is remeasured at each financial statement date until the award is settled or expires. During the three and nine months ended September 30, 2006, $4 and $2,033, respectively, was recorded as
expense based on the remeasurement of these options. An increase in the Companys stock price results in an additional expense pertaining to these unexercised options. Stock options to acquire 85,400 shares of common stock were exercised during
the nine months ended September 30, 2006 resulting in the reclassification of $4,761 to equity. As of September 30, 2006, $495 was included in other current liabilities for stock options to acquire 8,000 shares of common stock which
remained unexercised.

The fair value of liability awards was estimated using the Black-Scholes option pricing model and the following weighted average
assumptions:



|                            |  |       |  
|--------------------------- |  | ----- | -
|Dividend yield              |  | None  |  
|Expected volatility         |  | 100.0 | %
|Risk-free interest rate     |  | 4.7   | %
|Contractual life (in years) |  | 6.6   |  

Expected volatility is based on the historical volatility of the price of our common stock over the period
commensurate with the contractual life of the options. The contractual term of awards represents the contractual period of time that options granted are outstanding. The risk-free interest rate for periods within the contractual life of the option
is based on the U.S. Treasury yield curve in effect at the time of grant.

5. NOTE PAYABLE

In connection with the acquisition of Slim and Tone, the Company issued a $450 note payable to the seller. The seller note bears no interest and, as such, has been
recorded net of a discount of $43 computed at a 5.2% interest rate. Amortization of the note discount was $11 and $15 for the nine months ended September 30, 2006 and 2005, respectively. Under the terms of the note agreement, the Company made a
payment of $150 on December 31, 2005 and will make a payment of $150 on December 31, 2006 and 2007. The seller is now an employee of the Company.



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6. COMMITMENTS AND CONTINGENCIES

The Company is involved in various claims and litigation matters. In the opinion of management, after consultation with legal counsel, the outcome of such matters will not have a material adverse effect on the
Companys consolidated financial position, results of operations or cash flows in future years.

In 2004, the Company entered into two
employment agreements. The agreements have terms ranging from one to two years, with automatic one-year renewal terms. These agreements provide for base compensation of $225 for each employee per year and other fringe benefits and payments upon
termination. In 2005, the Company entered into an additional employment agreement. The agreement has a term of two years, with automatic one-year renewal terms. This agreement provides for base compensation of $200 per year and other fringe benefits
and payments upon termination. On July 25, 2006, one of the employees, who entered into an employment agreement in 2004, resigned.

In 2005,
the Company entered into a supply agreement with a food vendor. The agreement provides for annual pricing updates and rebates if certain volume thresholds are exceeded, as well as exclusivity in the production of certain products. As amended, the
agreement adjusts volume thresholds and extends the term that the Company will be required to make annual minimum purchases from the vendor until June 1, 2009. The Company anticipates it will meet the annual minimum purchases through 2009.

7. INCOME TAXES

The Company recorded taxes at an
estimated annual effective tax rate applied to income before income taxes of 38% in the three and nine months ended September 30, 2006. In the three and nine months ended September 30, 2005, the Company recorded taxes at an estimated
annual effective tax rate of 37% and 39%, respectively. In all periods, the estimated annual effective tax rate differed from the U.S. federal statutory rate of 35% primarily due to state income taxes. The Company offsets a portion of their taxable
income for federal and state tax purposes with net operating loss carryforwards. The Company has approximately $12,900 of federal net operating loss carryforwards at December 31, 2005, of which, approximately $11,000 will be utilized in 2006.
Approximately $2,500 of the $20,000 of state net operating loss carryforwards at December 31, 2005 will be utilized in 2006. Net operating losses will begin to expire in 2020.



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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

Except for the historical information contained herein, this Report on Form 10-Q contains certain forward-looking statements that involve substantial risks and uncertainties. Words such as may, should,
could, would, expect, plan, anticipate, believe, estimate, predict, continue, or similar words are intended to identify forward-looking
statements, although not all forward-looking statements contain these words. Our actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements. Factors that could
cause or contribute to such differences include those set forth in BusinessRisk Factors as disclosed in our Form 10-K filed on March 14, 2006 with the Securities and Exchange Commission. Accordingly, there is no assurance that
the results in the forward-looking statements will be achieved.

The following discussion should be read in conjunction with the
financial information included elsewhere in this Report on Form 10-Q.

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. We also own Slim and Tone LLC (Slim and Tone), a franchisor of womens express fitness centers. Slim and Tone franchisees sell our diet program in their centers as commissioned representatives. Substantially all of
our revenue is generated domestically.

Since our business began in 1972, it has operated in various organizational and legal structures,
and was subject to a bankruptcy proceeding in 1993, which was discharged in 1994. We became a publicly traded company in October 1999. In 2000, we changed our name from nutrisystem.com inc. to Nutri/System, Inc. and in 2003, we changed our name to
NutriSystem, Inc.

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 of our Annual Report on Form 10-K for the year ended December 31, 2005.

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 have been discussed with our audit committee.

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 three and nine
months ended September 30, 2006 was $11.1 million and $30.8 million, respectively, and $4.5 million and $9.4 million, respectively, for the three and nine months ended September 30, 2005. The reserve for returns incurred but not received
and processed was $4.3 million and $1.5 million at September 30, 2006 and December 31, 2005, respectively.

Impairment of
Fixed Assets and Intangibles. We continually assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Judgments regarding the existence of
impairment indicators are based on legal factors, market conditions and our operating performance. Future events could cause us to conclude that impairment indicators exist and the carrying values of fixed and intangible assets may be impaired. Any
resulting impairment loss would be limited to the value of net fixed and intangible assets.



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##### Table of Contents

Income Taxes. During 2005, the tax deduction from the exercise of certain stock options eliminated
taxable income on a tax return basis. As a result, we had federal net operating loss carryforwards of $12.9 million and state net operating loss carryforwards of $20.0 million at December 31, 2005. Approximately $11.0 million of the federal net
operating loss carryforwards and $2.5 million of state net operating loss carryforwards will be utilized in 2006. Net operating losses will begin to expire in 2020.

Currently, we are recording income taxes at a rate equal to the combined federal and state effective rates. For the three and nine months ended September 30, 2006, we recorded $14.3 million and $39.9 million,
respectively, of income taxes, which reflected estimated annual effective tax rates of 38%. For the three and nine months ended September 30, 2005, we recorded income tax expense of $4.3 million and $9.3 million, respectively, which reflected
estimated annual effective tax rates of 37% and 39%, respectively.

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. Revenue for Slim and Tone consists primarily of franchise fees and royalties. Revenue for franchise fees is recognized when a franchise center opens for business.
Royalties are paid monthly and recognized in the month the royalty is earned.

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 discounts, packing material and the write-off of obsolete packaging and product.
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. Cost of
revenue for Slim and Tone consists of the costs incurred associated with the opening of a franchise center.

Marketing Expense.
Marketing expense includes advertising, 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.

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 tax rate for the year.



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##### Table of Contents

Overview of the Direct Channel

In the nine months ended September 30, 2006 and 2005, the direct channel represented 92% and 87% of our revenue, respectively, and revenues grew 222%
year over year. 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. The spending on advertising and marketing
increased by $56.0 million to $87.5 million in the nine months ended September 30, 2006 from $31.5 million in the comparable period of 2005. Factors influencing our marketing effectiveness include the quality of the advertisements along with
the availability of appropriate media. In addition to our marketing efforts, we also generate new customers through referrals and publicity, such as magazine articles and mentions on television. 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 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 program new customer. These customers tend to stay on a weight loss program longer and spend substantially more than customers that make an initial
purchase of less than $100. Program customers made up 99% and 97% of all new customers, with an average acquisition cost of $138 and $137, in the nine months ended September 30, 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, and new program customer, acquired.

We measure revenue per customer two ways. First, we analyze revenue per customer obtained in the first nine months following a
customers initial purchase, referred to as the initial diet cycle. The revenue per customer in the initial diet cycle for a given month is the revenue obtained in that month from customers within nine months of their 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. For
comparative purposes, the trailing nine months revenue per customer was $543, $576, $609 and $605 for March 31, June 30, September 30, and December 31, 2005, respectively. The trailing nine months revenue per customer
was $617, $630, and $641 for March 31, June 30, and September 30, 2006, respectively. We believe these increases are primarily driven by the price increases and by increased unit purchases per customer. Reactivation revenue from
customers that were more than nine months removed from the initial purchase contributed approximately $10.6 million to revenue in the third quarter of 2006 compared to $2.3 million in the third quarter of 2005.

We also analyze revenue generated solely from new customers obtained in the current period divided by the number of new customers. For the third quarter
of 2006, new customer revenue per new customer increased 6% over the third quarter of 2005, or $22 per new customer. This increase was also driven by pricing and higher unit sales per customer.



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##### Table of Contents

Financial and Operating Statistics for the Direct Channel

(in thousands, except new customer data)



|                                  |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|--------------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                  |  | Three Months EndedSeptember 30, |         |   | Nine Months EndedSeptember 30, |  
|                                  |  | 2006                            |         |   | 2005                           |   |         | 2006 |  |   | 2005    |  
|Revenue                           |  | $                               | 143,547 |   |                                | $ | 57,670  |      |  | $ | 398,577 |   |  | $ | 123,939 |  
|                                  |  |                                 |         |  
|Cost of revenue                   |  |                                 | 65,013  |   |                                |   | 27,397  |      |  |   | 184,456 |   |  |   | 59,365  |  
|                                  |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Gross margin                      |  | $                               | 78,534  |   |                                | $ | 30,273  |      |  | $ | 214,121 |   |  | $ | 64,574  |  
|% of revenue                      |  |                                 | 54.7    | % |                                |   | 52.5    | %    |  |   | 53.7    | % |  |   | 52.1    | %
|                                  |  |                                 |         |  
|Marketing                         |  | $                               | 34,141  |   |                                | $ | 14,843  |      |  | $ | 87,548  |   |  | $ | 31,493  |  
|% of revenue                      |  |                                 | 23.8    | % |                                |   | 25.7    | %    |  |   | 22.0    | % |  |   | 25.4    | %
|                                  |  |                                 |         |  
|New customers                     |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Program                           |  |                                 | 233,762 |   |                                |   | 112,330 |      |  |   | 632,189 |   |  |   | 229,645 |  
|Total                             |  |                                 | 234,975 |   |                                |   | 115,115 |      |  |   | 637,469 |   |  |   | 237,124 |  
|                                  |  |                                 |         |  
|Marketing /new customer           |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Program                           |  | $                               | 146     |   |                                | $ | 132     |      |  | $ | 138     |   |  | $ | 137     |  
|Total                             |  | $                               | 145     |   |                                | $ | 129     |      |  | $ | 137     |   |  | $ | 133     |  
|                                  |  |                                 |         |  
|New customer revenue/new customer |  |                                 | .       |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Program                           |  | $                               | 388     |   |                                | $ | 373     |      |  | $ | 530     |   |  | $ | 491     |  
|Total                             |  | $                               | 386     |   |                                | $ | 364     |      |  | $ | 525     |   |  | $ | 475     |  

In the third quarter of 2006, direct revenue increased 149% over the third quarter of 2005. This
increase was primarily driven by increased marketing spend that resulted in a 104% increase in new customers over the same period of the prior year. Marketing spend increased 130%, or $19.3 million, in the third quarter of 2006 compared to 2005.

Direct gross margin increased to 54.7% in the third quarter of 2006 from 52.5% in the third quarter of 2005, primarily driven by the 3.5%
price increase and lower food and outbound freight costs.

Marketing cost per customer increased from $129 to $145 from the third quarter
2005 to 2006. Marketing cost per program customer increased from $132 to $146 in the same periods. The higher marketing cost per program customer can be attributed to the significant increase in marketing spend, particularly spending to promote the
mens program. The marketing cost to acquire a male customer was higher than the cost to acquire a female customer in the third quarter. We initiated marketing of our mens program in January 2006. In 2005, men made up approximately 13% of
new customers; in the third quarter of 2006, men made up approximately 29% of new customers.



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##### Table of Contents

Overview of Distribution via a Home Shopping Network

We distribute our proprietary prepackaged food through QVC, a television home shopping network. In the nine months ended September 30, 2006, this
channel represented 6% of our revenue as compared to 9% of our revenue in the comparable period of 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 with QVC, QVC viewers purchase NutriSystem products directly from QVC and are not directed to the NutriSystem web site. Retail prices (including shipping and handling) offered on QVC to consumers are
similar to prices offered on the web site. We generate a lower gross margin (as a percent of revenue) on sales to 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 $9.2 million and $28.1 million for the three and nine months ended September 30, 2006 compared to $4.7 million and $13.3 million for the three and
nine months ended September 30, 2005, respectively. QVC sales are a function of the number of shows and the sales per minute on each show. Sales increased for the three and nine months ended September 30, 2006 versus 2005 because more
shows aired and the sales per minute of air-time increased.



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##### Table of Contents

Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005



|                              |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|----------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------ | -------- |  | -------- | ------ |  | --- | -
|                              |  | Three Months Ended September 30, |        
|(In Thousands)                |  | 2006                             |         |   | 2005 |   |        | $ Change |  | % Change |       
|REVENUE                       |  | $                                | 155,258 |   |      | $ | 64,518 |          |  | $        | 90,740 |  | 141 | %
|                              |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|COSTS AND EXPENSES:           |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|Cost of revenue               |  |                                  | 73,697  |   |      |   | 32,697 |          |  |          | 41,000 |  | 125 | %
|Marketing                     |  |                                  | 34,143  |   |      |   | 14,968 |          |  |          | 19,175 |  | 128 | %
|General and administrative    |  |                                  | 10,025  |   |      |   | 5,506  |          |  |          | 4,519  |  | 82  | %
|Depreciation and amortization |  |                                  | 715     |   |      |   | 232    |          |  |          | 483    |  | 208 | %
|                              |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|Total costs and expenses      |  |                                  | 118,580 |   |      |   | 53,403 |          |  |          | 65,177 |  | 122 | %
|                              |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|Operating income              |  |                                  | 36,678  |   |      |   | 11,115 |          |  |          | 25,563 |  | 230 | %
|INTEREST INCOME, net          |  |                                  | 1,061   |   |      |   | 330    |          |  |          | 731    |  | 222 | %
|                              |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|Income before income taxes    |  |                                  | 37,739  |   |      |   | 11,445 |          |  |          | 26,294 |  | 230 | %
|INCOME TAXES                  |  |                                  | 14,341  |   |      |   | 4,250  |          |  |          | 10,091 |  | 237 | %
|                              |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|Net income                    |  | $                                | 23,398  |   |      | $ | 7,195  |          |  | $        | 16,203 |  | 225 | %
|                              |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|% of revenue                  |  |                                  |         |   |      |   |        |          |  |          |        |  |     |  
|                              |  |                                  |         |  
|Gross margin                  |  |                                  | 52.5    | % |      |   | 49.3   | %        |  |          |        |  |     |  
|Marketing                     |  |                                  | 22.0    | % |      |   | 23.2   | %        |  |          |        |  |     |  
|General and administrative    |  |                                  | 6.5     | % |      |   | 8.5    | %        |  |          |        |  |     |  
|Operating income              |  |                                  | 23.6    | % |      |   | 17.2   | %        |  |          |        |  |     |  

Revenue. Revenue increased to $155.3 million in the third quarter of 2006 from $64.5
million for the third quarter of 2005. The direct channel accounted for 92% of total revenue in the third quarter of 2006 compared to 6% for QVC and 2% for the other channels. In the third quarter of 2005, the direct channel accounted for 89% of
total revenue compared to 7% for QVC and 4% for the other channels. The revenue increase of $90.7 million, or 141%, resulted primarily from increased direct sales ($85.9 million) and QVC sales ($4.5 million).

Costs and Expenses. Cost of revenue increased $41.0 million to $73.7 million in the third quarter of 2006 from $32.7 million in the third quarter
of 2005. Gross margin as a percent of revenue increased to 52.5% in the third quarter of 2006 from 49.3% for the third quarter of 2005. The increase in gross margin was primarily attributable to a 3.5% price increase in the direct channel, lower
food and outbound freight costs and the shift in the mix toward the higher margin direct channel.

Marketing expense increased $19.2
million to $34.1 million in the third quarter of 2006 from $15.0 million in the third quarter of 2005. Marketing expense as a percent of revenue decreased to 22.0% in the third quarter of 2006 from 23.2% for the third quarter of 2005. Almost all
marketing spending promoted the direct business, and the increase in marketing is primarily attributable to increased spending for advertising media ($18.6 million) and the production of television advertising ($403,000). In total, advertising media
expense was $32.0 million in the third quarter of 2006 and $13.4 million in the third quarter of 2005.

General and administrative expenses
increased $4.5 million to $10.0 million in the third quarter of 2006 compared to $5.5 million in the third quarter of 2005, but as a percent of revenue decreased to 6.5% in the third quarter of 2006 from 8.5% for the third quarter of 2005. The
absolute dollar increase is due primarily to higher costs associated with the increased scale of the business, especially compensation and benefits costs ($2.3 million) primarily due to additional headcount; increased professional and outside
services ($710,000); and non-cash expense for share-based payment arrangements ($677,000).



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##### Table of Contents

Operating Income. Operating income increased $25.6 million to $36.7 million in the third quarter
of 2006 compared to $11.1 million in the third quarter of 2005. As a percent of revenue, operating income increased to 23.6% in the third quarter of 2006 from 17.2% in the third quarter of 2005. The adoption of SFAS No. 123R resulted in a
non-cash share-based expense of $677,000 in the third quarter of 2006. Excluding these charges, operating income represented 24.1% of revenue.

Interest Income, Net. Interest income, net, increased $731,000 to $1.1 million in the third quarter of 2006 compared to $330,000 in the third quarter of 2005 primarily due to higher cash balances and investments in marketable
securities.

Income Taxes. In the third quarter of 2006, we recorded income tax expense of $14.3 million, which reflects an
estimated annual effective tax rate of 38%. The estimated annual effective tax rate differed from the U.S. federal statutory rate of 35% primarily due to state income taxes. In the third quarter of 2005, we recorded income tax expense of $4.3
million, which reflected an estimated annual effective tax rate of 37%.

Net Income. Net income increased $16.2 million to $23.4
million in the third quarter of 2006 compared to $7.2 million in the third quarter of 2005. The increase in net income is primarily due to higher gross profit from increased revenue offset by higher advertising and marketing spending and general and
administrative expenses.



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##### Table of Contents

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005



|                              |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|----------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | -------- |  | -------- | ------- |  | --- | -
|                              |  | Nine Months Ended September 30, |        
|(In Thousands)                |  | 2006                            |         |   | 2005 |   |         | $ Change |  | % Change |        
|REVENUE                       |  | $                               | 434,640 |   |      | $ | 142,889 |          |  | $        | 291,751 |  | 204 | %
|                              |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|COSTS AND EXPENSES:           |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|Cost of revenue               |  |                                 | 210,876 |   |      |   | 74,021  |          |  |          | 136,855 |  | 185 | %
|Marketing                     |  |                                 | 87,829  |   |      |   | 31,870  |          |  |          | 55,959  |  | 176 | %
|General and administrative    |  |                                 | 31,215  |   |      |   | 12,784  |          |  |          | 18,431  |  | 144 | %
|Depreciation and amortization |  |                                 | 1,833   |   |      |   | 579     |          |  |          | 1,254   |  | 217 | %
|                              |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|Total costs and expenses      |  |                                 | 331,753 |   |      |   | 119,254 |          |  |          | 212,499 |  | 178 | %
|                              |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|Operating income              |  |                                 | 102,887 |   |      |   | 23,635  |          |  |          | 79,252  |  | 335 | %
|                              |  |                                 |         |  
|INTEREST INCOME, net          |  |                                 | 2,529   |   |      |   | 390     |          |  |          | 2,139   |  | 548 | %
|                              |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|Income before income taxes    |  |                                 | 105,416 |   |      |   | 24,025  |          |  |          | 81,391  |  | 339 | %
|                              |  |                                 |         |  
|INCOME TAXES                  |  |                                 | 39,893  |   |      |   | 9,282   |          |  |          | 30,611  |  | 330 | %
|                              |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|Net income                    |  | $                               | 65,523  |   |      | $ | 14,743  |          |  | $        | 50,780  |  | 344 | %
|                              |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|% of revenue                  |  |                                 |         |   |      |   |         |          |  |          |         |  |     |  
|                              |  |                                 |         |  
|Gross margin                  |  |                                 | 51.5    | % |      |   | 48.2    | %        |  |          |         |  |     |  
|Marketing                     |  |                                 | 20.2    | % |      |   | 22.3    | %        |  |          |         |  |     |  
|General and administrative    |  |                                 | 7.2     | % |      |   | 8.9     | %        |  |          |         |  |     |  
|Operating income              |  |                                 | 23.7    | % |      |   | 16.5    | %        |  |          |         |  |     |  

Revenue. Revenue increased to $434.6 million for the nine months ended September 30,
2006 from $142.9 million for the comparable period in 2005. The direct channel accounted for 92% of total revenue in the nine months ended September 30, 2006 compared to 6% for QVC and 2% for the other channels. In the comparable period of
2005, the direct channel accounted for 87% of total revenue compared to 9% for QVC and 4% for the other channels. The revenue increase of $291.8 million, or 204%, resulted primarily from increased direct sales ($274.6 million) and QVC sales ($14.8
million).

Costs and Expenses. Cost of revenue increased to $210.9 million in the nine months ended September 30, 2006 from
$74.0 million for the comparable period in 2005. Gross margin as a percentage of revenue increased to 51.5% in the nine months ended September 30, 2006 from 48.2% for the comparable period in 2005. The increase in gross margin was primarily
attributable to a 3.5% price increase, lower food costs and outbound freight costs and the shift in the mix toward the higher margin direct channel.

Marketing expense increased to $87.8 million in the nine months ended September 30, 2006 from $31.9 million in the comparable period in 2005. Marketing expense as a percent of revenue decreased to 20.2% in the
nine months ended September 30, 2006 from 22.3% in the comparable period in 2005. Almost all marketing spending promoted the direct business, and the increase in marketing is attributable to increased spending for advertising media ($54.1
million), production of television advertising ($864,000) and payroll related to marketing and advertising ($485,000). In total, advertising media expense was $83.2 million in the nine months ended September 30, 2006 and $29.1 million in the
comparable period of 2005.

General and administrative expenses increased to $31.2 million for the nine months ended September 30,
2006 from $12.8 million for the comparable period in 2005, but as a percent of revenue decreased to 7.2% in the nine months ended September 30, 2006 from 8.9% in the comparable period in 2005. The absolute dollar increase of $18.4 million is



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##### Table of Contents

due primarily to higher costs associated with the increased scale of the business, especially compensation and benefits
($8.8 million); the non-cash expense for unexercised non-employee consultants stock options ($2.0 million); non-cash expense for employee share-based payment arrangements ($2.2 million); and professional and outside services ($1.8 million).

Interest Income, net. Interest income, net increased to $2.5 million in the nine months ended September 30, 2006 compared to
$390,000 in the comparable period in 2005 primarily due to higher cash balances and investments in marketable securities.

Income
Taxes. In the nine months ended September 30, 2006, we recorded $39.9 million of income taxes due to the income for the current reporting period, which was recorded at an estimated annual effective tax rate of 38%. The estimated annual
effective tax rate differed from the U.S. federal statutory rate of 35% primarily due to state income taxes. For the nine months ended September 30, 2005, we recorded income tax expense of $9.3 million, which reflected an estimated annual
effective tax rate of 39%.

Net Income. We recorded net income of $65.5 million for the nine months ended September 30, 2006
compared to $14.7 million for the comparable period in 2005. The increase of $50.8 million is primarily due to higher gross profit from increased revenue offset by higher advertising and marketing spending and general and administrative expenses.

Contractual Obligations and Commercial Commitments

As of September 30, 2006, our principal commitments consisted of an obligation under a supply agreement with a food vendor, a capital lease, operating leases, employment contracts and a note payable related to
the Slim and Tone acquisition. 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 nine months ended September 30, 2006, a supply agreement with a food vendor was amended to adjust volume thresholds
and extend the term that we will be required to make annual minimum purchases from the vendor through June 1, 2009. We anticipate we will meet the annual minimum purchases through 2009. In addition, we have no off balance sheet financing
arrangements.

Liquidity, Capital Resources and Other Financial Data

At September 30, 2006, we had net working capital of $103.5 million, including cash, cash equivalents and marketable securities of $101.7 million,
compared to net working capital of $65.5 million at December 31, 2005. Our principal source of liquidity during this period was cash flow from operations. At September 30, 2006, we had no bank debt or term or revolving credit facilities to
fund operations or investment opportunities. In connection with the acquisition of Slim and Tone, we have a seller note obligation of $300,000 at September 30, 2006. We currently have no off-balance sheet financing arrangements. Cash and cash
equivalents include cash and highly liquid investments purchased with an original maturity of three months or less. At September 30, 2006, cash equivalents consist of monies in money market accounts and marketable securities consist of
auction-rate certificates with original maturities of greater than three months as more fully described in Note 2 of the consolidated financial statements.

In the nine months ended September 30, 2006, net cash flow generated by operations was $93.4 million, an increase of $68.1 million from the $25.3 million of operating cash flow generated in the nine months ended
September 30, 2005. This increase was caused by higher net income and favorable working capital changes. Net changes in operating assets and liabilities increased cash flow from operations by $18.5 million in the nine months ended
September 30, 2006. The decrease in inventory ($7.5 million) was caused by lower production levels of existing products in anticipation of the introduction of new and improved items in the near future. Additionally, increases in accounts
payable ($4.2 million), accrued income taxes ($6.2 million) and accrued payroll and related benefits ($3.8 million) provided favorable working capital changes. In the fourth quarter of 2006, we expect to grow our inventory balances in anticipation
of the increased sales in the first quarter of 2007.

In the nine months ended September 30, 2006, net cash used in investing
activities consisted of net purchases of marketable securities of $53.4 million and $4.4 million in capital expenditures. The capital expenditures relate primarily to information technology, office and leasehold improvements for expansion and
warehouse equipment.



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##### Table of Contents

In the nine months ended September 30, 2006, net cash used in financing activities consisted of the
repurchase of 896,700 shares of common stock for an aggregate purchase price of $45.4 million partially offset by the tax benefit from stock option exercises of $8.8 million and cash receipts of $2.7 million from the exercise of common stock
options.

Our Board of Directors has authorized the repurchase of up to $50 million of our outstanding shares of common stock. The stock
repurchase program does not have an expiration date and may be limited or terminated at any time without prior notice. The repurchased shares have been retired.

There are no current plans or discussions in process relating to any material acquisition that is probable in the foreseeable future.

We have not declared or paid any dividends since inception. The Board of Directors has considered the declaration of a dividend and expects to give it further consideration in the future. The declaration and payment
of dividends in the future will be determined by our Board of Directors in light of conditions then existing, including our earnings, financial condition, capital requirements and other factors.

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 price and availability of certain media.
However, in 2005, our revenue increased sequentially every quarter due to our increased level of advertising spending and, in 2006, the third quarter was higher than the first quarter. We believe the overall impact of seasonality on revenue is
difficult to predict at this time.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

We do not hold any investments in
market risk sensitive instruments. Accordingly, we believe that we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect
market risk instruments. We do not have any variable interest debt outstanding at September 30, 2006, our cash and cash equivalents at that date of $5.6 million were maintained in bank accounts and our marketable securities at that date of
$96.1 million had interest rate reset dates of three months or less. As such, a change in interest rates of 1 percentage point would not have a material impact on our operating results and cash flows.

Item 4. Controls and Procedures

The Companys Chief Executive Officer and Chief Financial Officer
evaluated the effectiveness of the design and operation of the Companys disclosure controls and procedures as of September 30, 2006. Based upon this evaluation, they concluded that, as of the date of the evaluation, the Companys
disclosure controls and procedures as of September 30, 2006 have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by the Company in reports filed under the Securities
Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms. Management believes that a control system, no matter how well designed and operated, cannot provide absolute
assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. Since the date of this
evaluation, there have been no significant changes in the Companys internal controls or in other factors that could significantly affect those controls.



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##### Table of Contents

PART II  OTHER INFORMATION

Item 1. Legal Proceedings

None

Item 1A. Risk Factors

There have been no material changes to the factors disclosed in Item 1A.
Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2005.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The following table provides
information relating to our purchases of our common stock during the quarter ended September 30, 2006:



|                                 |  |                                |  |                             |       |                                                                                  |         |                                                                                          |   |          
|-------------------------------- |  | ------------------------------ |  | --------------------------- | ----- | -------------------------------------------------------------------------------- | ------- | ---------------------------------------------------------------------------------------- | - | ---------
|Period                           |  | Total Number ofSharesPurchased |  | Average PricePaid per Share |       | Total Number ofShares Purchased asPart of PubliclyAnnounced Plans orPrograms
(1) |         | Approximate DollarValue of Shares thatMay Yet
BePurchased Under thePlans or Programs (1)
|August 1, 2006  August 31, 2006 |  | 865,000                        |  | $                           | 50.62 |                                                                                  | 865,000 |                                                                                          | $ | 6,211,812
|September 1  September 30, 2006 |  | 31,700                         |  | $                           | 49.83 |                                                                                  | 31,700  |                                                                                          | $ | 4,632,229

---

|(1) | On August 1, 2006, we announced that our Board of Directors authorized the repurchase of up to $50 million of our outstanding shares of common stock in open-market transactions
on the Nasdaq National Market. The timing and actual number of shares repurchased depend on a variety of factors including price, corporate and regulatory requirements, alternative investment opportunities and other market conditions. The stock
repurchase program does not have an expiration date and may be limited or terminated at any time without prior notice.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

None

Item 5. Other Information

None

Item 6. Exhibits

31.1 Certifying Statement of the Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certifying Statement of the Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002

32.1 Certifying Statement of the Chief Executive Officer pursuant to Section 1350 of Title 18 of the
United States Code

32.2 Certifying Statement of the Chief Financial Officer pursuant to Section 1350 of Title 18 of the United States
Code



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##### Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to
be signed on its behalf by the undersigned, thereunto duly authorized.



|                  |  |                                                                            |  |                 
|----------------- |  | -------------------------------------------------------------------------- |  | ----------------
|NutriSystem, Inc. |  |                                                                           
|                  |  |                                                                           
|BY:               |  | /S/ MICHAEL J. HAGAN                                                       |  | November 7, 2006
|                  |  | Michael J. Hagan                                                           |  |                 
|                  |  | Chairman and Chief Executive Officer                                       |  |                 
|                  |  | (principal executive officer)                                              |  |                 
|                  |  |                                                                           
|BY:               |  | /S/ JAMES D. BROWN                                                         |  | November 7, 2006
|                  |  | James D. Brown                                                             |  |                 
|                  |  | Executive Vice President, Chief Financial Officer, Secretary and Treasurer |  |                 
|                  |  | (principal financial and accounting officer)                               |  |                 



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##### Table of Contents

Exhibit Index



|     |  |                                                                                                                   
|---- |  | ------------------------------------------------------------------------------------------------------------------
|No.  |  | Description                                                                                                       
|31.1 |  | Certifying Statement of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002     
|     | 
|31.2 |  | Certifying Statement of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002     
|     | 
|32.1 |  | Certifying Statement of the Chief Executive Officer pursuant to Section 1350 of Title 18 of the United States Code
|     | 
|32.2 |  | Certifying Statement of the Chief Financial Officer pursuant to Section 1350 of Title 18 of the United States Code



25