Feb 8, 2023
Medifast, Inc, NYSE: MED
10 yr CAGR (per share)
•Revenue: 18.7%
•Owner earnings: 21.3%
•Capital spending: 11.2%
•Book value: 13%
Summary
Founded in 1981, MED produces and sells weight loss and weight management products under its OPTAVIA brand and community. The company’s marketing is primarily driven by independent “Coaches” who source clients through word of mouth, social media, email marketing, etc. MED’s products are largely sold in the US but an expansion into Hong Kong and Singapore took place in 2019.
90% of the company’s independent coaches were clients first.
All sales are effectuated through the company’s direct-to-consumer channels. Coaches do not maintain product inventories.
As of 3Q 2022, MED had 66,200 actively selling coaches producing average annual revenue for the company of $5897. These numbers have grown steadily in recent years but average revenue per coach softened in mid-2022 from $6773 in Q3 2021.
MED manufactures approximately 17% of its products while third-parties manufacture the balance.
The diet and weight loss space is highly competitive with WW International (Weight Watchers) and Herbalife being competitors.
Risks to Investment Thesis
•Although the company has had a great deal of success growing both actively selling coaches and average annual revenue per coach, a reversal in the trend would negatively impact MED.
•There is substantial competition for the attention of dieters. Not only from direct competitors like Weight Watchers or HerbaLife but also from popular diets like Keto or Atkins.
•To stay relevant the company needs to continually create new products that resonate with consumers.
•Reputational risks could arise from publicity surrounding regulatory penalties, litigation for product liability or claims of ineffective products, etc.
•Regulatory risks are numerous. For example, FTC penalties for making false claims or failing to conform to rules against pyramid schemes. While regulatory penalties would directly impact expenses in the short-term, they could indirectly affect revenue indefinitely if it damaged the Company’s reputation. In 2019 the FTC sued a competitor, Advocare, for $149 million alleging it operated as an illegal pyramid scheme.
•Given the level of competition, it is fair to assume there is a terminal market share above which the Company’s growth rate will slow significantly. In the 2021 10-K, MED estimates that the US market for weight loss products is $20 billion. Making the presumption that 10% market share is near terminal, as MED’s US sales approach $2 billion it’s expected annual growth rate could decline meaningfully.
•MED has experienced margin compression since 2021. Net margin is likely to come in around 9% for 2022. Tighter margins may not be fully cyclical in nature and may not recover to the 11% seen in 2020.
•Supply disruption risks are amplified by 83% of products being produced by third parties.
Management
For biographical details of executive-level management and the board of directors see the Company’s proxy statement.
In my estimation, management is fully qualified to continue leading MED to future profitable growth.
Compensation Structure
The Company’s compensation structure is reasonable and incentivizes medium-term financial performance.
Each named executive officer receives a modest base salary, an incentive bonus and equity awards.
The incentive bonus is stated as a target opportunity ranging from 50-115% of base salary. It is paid based on different threshold levels of performance resulting in 0-200% of the target opportunity. The performance metrics are operating income receiving a weight of 60% and revenue being weighted at 40%.
Equity awards are weighted 60% for performance and 40% are time-based.
Performance-based deferred shares are earned to the extent of achieving performance goals derived from operating income and revenue over a three year period.
Time-based restricted share grants are vested over a three year period.
Investment Thesis
MED has experienced significant growth since 2017. And market valuations were representative of a high growth company with the share price hitting $330+ in mid-2021 and a GAAP P/E north of 30.
General market action, a slowing of revenue growth in 2022, and margin compression have contributed to a major sell-off in MED’s shares.
Despite a slowing of sales growth, MED is an excellent company.
•10 year average return on equity of 45% with no debt
•MED’s capital spending requirements are low. CapEx in 2021 was unusually high at nearly $3/shr compared to $0.50/shr in 2020 and a 5 year average of $1/shr. I expect to see a slight decrease in CapEx per share in the 2022 results with a medium-term expectation of settling in around $1.
•Low operating leverage allows for solid cash flow without massive sales growth
•No debt in the capital structure
•90% of coaches started as customers indicating they believe in the efficacy of the diet program and are energized to sell it. This point is also a mitigating factor for reputational risk tied to the potential for accusations of being a pyramid scheme. A key indicator for an illegal pyramid scheme is an emphasis on recruiting salespeople over actually selling products to consumers.
•Direct-to-consumer sales model lowers barriers for recruiting new coaches due to a lack of inventory investment. It also reduces the risk of unsavory sales tactics by coaches to sell unpopular product.
•It’s doubtful MED has reached a terminal market share in the US. It is likely that potential sales growth in the domestic market remains considerable.
•Competitors have seen strong sales in Asia. MED’s expansion to Hong Kong and Singapore is likely to result in meaningful sales growth well into the future.
•Roughly 13% of MED’s outstanding shares are authorized to be repurchased. At the current price, share repurchases add significant value on a per share basis.
Valuation Assumptions
Based on performance targets for executive bonuses, the company has a baseline revenue growth goal of 15% annually.
Given MED’s history of growth, 15% seems reasonable. However, 6% is more palatable for the purpose of calculating value. 6% was chosen as it is my expectation for the current year revenue growth. This also minimizes the impact on the value estimate of any future growth in Asian markets; which, without historical data, I view as speculative.
I’m also making the assumption that net margin compression is not cyclical but, rather, mean reverting. A long-term net margin of 8% is being assumed compared to 10 year averages of 8.9% on a GAAP basis and 8.88% on an “owner earnings” basis.
I use “owner earnings” (operating cash flow minus maintenance capex) for value calculation. In MED’s case, owner earnings and GAAP earnings margins closely track each other on a 10 year average.
These assumptions are quite conservative compared to MED’s history. But they allow the estimates to be a high probability potential outcome.
Valuation
Given the assumptions, a range of owner earnings P/E ratios based on historical annual averages, a discount rate of 2x the AAA corporate bond rate, and the antidilutive impact of MED’s authorized share repurchases netted against share-based compensation, it is my opinion that the current value of MED is $200-$220 per share.
A downside analysis assumes no future revenue growth and a halving of the historical P/E. The result is an undiscounted value of $130 per share and a discounted value of $80 per share.
Considering the conservative nature of the value assumptions combined with a current share price of $115, I believe MED stock offers a comfortable margin of safety and downside protection while clearly having incredible asymmetric upside.
Catalyst
MED was a highflying growth stock with a market valuation to prove it hitting a peak in May 2021. Since then general market action, a slowing of revenue growth, and inflationary headwinds have led to a significant decline in its share price. I believe the sell-off is way overdone.
•A broad realization that MED is a strong cash producer with or without double digit sales growth would elevate shares closer to its intrinsic value.
•A return to sales growth comparable 2017-2020 could send the shares soaring again.
•In either case, MED is significantly undervalued at today’s share price. Overtime the discrepancy with correct itself.
Disclosure:
MED is currently about 5% of my portfolio at an average cost of $111.50 per share. Depending on price action, I may increase, reduce, or close the position without updating this report.
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