2023-11-09 08:40:22 ET
Summary
- Medifast, Inc. stock is down 80% from its mid-2021 peak, and from a valuation perspective, it looks like a veritable deep-value opportunity.
- Medifast is currently facing challenges due to elevated consumer price inflation, but increasingly also due to weight loss drugs like Wegovy and soon also Zepbound (or at least their narrative).
- In this article, I take a look at Medifast's business model, its profitability, and its balance sheet quality against the backdrop of this undoubtedly challenging environment.
- I also discuss MED's Q3 earnings and whether there is any truth to the theory that GLP-1 receptor agonists pose an existential threat to Medifast's business model.
- However, I also highlight another potential investment risk that relates to Medifast's most important asset - its coaches.
Introduction
Medifast, Inc. (MED) shareholders are not exactly in an enviable position considering the stock has lost 80% since its peak in mid-2021. I started following the company when the stock broke through the $100 mark in April 2023, but have not yet made a move to build a position in the company.
Since I haven't covered MED stock before, I'll briefly discuss Medifast's business model and take a look at the company's profitability and balance sheet quality. In addition, I will share my take on the company's recent earnings report (MED reported third-quarter results on November 6) and whether there is any truth to the theory that glucagon-like peptide 1 (GLP-1) receptor agonists such as semaglutide (marketed by Novo Nordisk A/S, NVO , as Ozempic and Wegovy) pose an existential threat to Medifast's business model. However, I will also point out another potential investment risk that relates to Medifast's most important asset - its coaches. Finally, I will outline whether I think the stock is a buy now that it is trading at an undoubtedly compelling valuation of less than seven times earnings and a free cash flow yield of 17%.
Medifast - A Look At Its Business, Profitability, Balance Sheet And Q3 Earnings
Medifast is, as the name suggests, active in the market for weight loss products. However, its business model is special in that its products (sold under the OPTA VIA brand) are marketed through so-called coaches, most of whom (90% according to Medifast, p. 4, 2022 10-K ) have successfully lost weight by following the strategy that combines selected nutritional products and plans involving habitual changes and fitness programs. A significant part of the company's success (in 2021 it was named the #1 weight loss program in the U.S. in terms of sales) is due to the high level of conviction of the Medifast coaches, their inspiring nature and, of course, the sense of community (" OPTA VIA community").
With a gross margin of 74% (Q1 2019 to Q3 2023 average), Medifast looks like a very attractive business to own. Selling, general and administrative (SG&A) expenses, however, are naturally high as they include coach compensation (more on this later) and understandably pronounced advertising expenses. Nevertheless, Medifast is solidly profitable with an average operating margin of 13%. The company also generates very healthy free cash flow, and thanks to its very lean asset base, both its return and cash return on invested capital ((ROIC/CROIC)) are extremely solid (Figure 1) and well above the cost of capital, which is almost entirely the cost of equity, as the company has no interest-bearing debt other than $22 million in lease-related obligations. The Capital Asset Pricing Model derived cost of equity is currently 10.3%, meaning that the company generates ample excess returns on its invested capital.
Figure 1: Medifast, Inc. (MED): Return and cash return on invested capital; free cash flow after stock-based compensation and working capital-related adjustments (own work, based on company filings)
Nevertheless, it is reasonable to expect at least some moderation in free cash flow and hence CROIC as the company is currently reducing its extensive inventory levels which of course boosts free cash flow (Figure 2, blue bars). That said, it would be far-fetched to accuse the company of boosting its free cash flow through unsustainable growth in its accounts payable (Figure 2, red bars). In fact, Medifast has reduced its payables relative to sales, which could be a sign of a weaker negotiating position with its suppliers. Unsurprisingly, the days payable outstanding ((DPO)) ratio has fallen from typically over 60 days to between 45 and 50 days in recent years.
Figure 2: Medifast, Inc. (MED): Inventories and accounts payable & accrued expenses in % of revenue (own work, based on company filings)
As mentioned above, the company has no interest-bearing debt on its balance sheet, apart from the $22 million in lease-related obligations (7% of total assets), the maturities of which are spread evenly over the next few years. With cash and cash equivalents of $113 million and a cash and current ratio of 1.03 and 2.04 at the end of the third quarter of 2023, respectively, the company's liquidity position is very strong indeed, even though most of Medifast's liabilities are short-term in nature. A high current ratio and low fixed assets imply a high equity ratio (Figure 3), and this is largely tangible in nature, as Medifast has no goodwill or significant other intangible assets on its balance sheet .
Figure 3: Medifast, Inc. (MED): Equity ratio (own work, based on company filings)
In my view, the company's very solid balance sheet and good profitability are important assets in what appears to be a very difficult environment. Quarterly results were once again quite disappointing, with third-quarter sales down 40% year-over-year and more than 20% sequentially (Figure 4). Operating profit for the quarter fell by 47% (Figure 5). The fact that the decline in operating profit is roughly in line with the decline in sales is a positive sign and confirms the company's low dependence on fixed assets and low operating leverage. However, it is important to take a closer look at the company's cost structure before jumping to the conclusion that the decline in sales is not actually a serious problem and is merely a result of the cyclicality of the business.
Figure 4: Medifast, Inc. (MED): Quarterly revenue and year-over-year change (own work, based on company filings) Figure 5: Medifast, Inc. (MED): Quarterly operating earnings and year-over-year change (own work, based on company filings)
Medifast's Challenges
The company's unique approach through high-margin nutritional products and truly committed coaches suggests that this is a highly efficient business model, but one that also exposes the company to the ups and downs in the labor market. As with many business models involving 'entrepreneurial' sole proprietorships, a well-designed incentive structure is key to retaining contractors even in difficult times.
Medifast is currently in a difficult environment for two reasons. Firstly, more and more available GLP-1 receptor agonists seem to make losing weight a more or less effortless endeavor (at least in theory) and could therefore render Medifast's business model obsolete. That being said, the company's management is embracing the idea of offering GLP-1 receptor agonists to support weight loss in the company's programs. However, I find it hard to imagine that Medifast's original business model can continue to thrive in such an environment and expect that the company's profit margins would suffer significantly.
Of course, it is not the case that everyone will suddenly start injecting themselves with these drugs just because they can achieve a good figure without a healthy diet and exercise and despite a relaxed lifestyle (at least in theory). In fact, according to a study referenced by management during the Q3 earnings call , half of Medifast's addressable market even rejects the supplementary use of such therapies. There are a number of possible reasons why such a significant percentage would reject the use of Wegovy (and soon Eli Lilly's ( LLY ) Zepbound/tirzepatide ). I hypothesize that the route of administration of Zepbound, for example ( weekly subcutaneous injection ), plays an important role in this context. If this hypothesis proves to be true, I believe that the currently heavily researched oral GLP-1 receptor agonists (e.g. orforglipron, Eli Lilly ) could be a black swan for Medifast.
However, it is also important to keep an eye on inflation, which is still high. Medifast's programs are far from cheap and are ultimately a discretionary expense that is likely to be one of the first to be foregone when disposable income suffers.
In my view, the decline in demand for Medifast's products and services due to the increasing availability of weight loss medications (or at least the narratives associated with them) and continued high inflation can best be seen in the number of active coaches. Since peaking in Q2 2022, the number of active coaches has been declining, and with it revenue per coach - an obvious double whammy compared to the pre-2022 period (Figure 6). Q3 2023 was another weak quarter with 29% fewer active coaches than a year ago and 11% fewer than the previous quarter.
Figure 6: Medifast, Inc. (MED): Active independent coaches and quarterly revenue per coach (own work, based on company filings)
Admittedly, the company boasts a very solid gross margin (see above), but this should not be over-interpreted due to the very high SG&A expenses, which are largely attributable to coach compensation. The company did not break down the actual contribution of coach compensation to SG&A expenses in its 2022 10-K, but it did so in its previous (p. 33) and earlier annual reports, according to which coach compensation accounts for 70% of total SG&A expenses (2019 - 2021 average).
I was therefore somewhat surprised that relative SG&A costs actually fell when inflation started to rise (Figure 7). While I realize that the company needs to cut costs in order to be less aggressive with price increases to consumers, I think it's a dangerous game to cut back on coach compensation. From this perspective, it is reassuring to see that relative SG&A expenses are increasing, having bottomed out at 55% of sales in the first quarter of 2023. Against this backdrop, however, it is concerning that the company apparently no longer discloses actual coach compensation.
Figure 7: Medifast, Inc. (MED): Gross margin and relative selling, general & administrative expenses (own work, based on company filings)
Admittedly, the above approach is a very rough approximation, so it makes sense to look at coach compensation from a different perspective. Dividing the average SG&A expense contribution attributable to coach compensation (70%, 2019 to 2021 average) gives the average quarterly compensation per coach (Figure 8). Of course, this is also an approximation, but it serves its purpose well enough. Even if we assume the contribution of coach compensation to SG&A expenses was higher in 2022 in relative terms and the first nine months of 2023, it is very unlikely that the conclusion from Figure 8 - that coach earnings are under pressure.
Figure 8: Medifast, Inc. (MED): Quarterly coach compensation, estimated via the 2019 - 2021 average coach commission as a percentage of SG&A expenses (own work, based on company filings)
While I acknowledge that I have disregarded potential long-term incentives that should improve coach retention, the downward trend in estimated coach compensation is disappointing and actually makes me question the sustainability of Medifast's original business model - especially in light of the increasing acceptance of weight loss medications and what I believe to be a "higher for longer" environment (not necessarily in terms of interest rates, but in terms of inflation). In addition, I wouldn't underestimate the impact of the narrative around these incretin mimics from a coach's perspective either. With the extensive social media coverage, existing coaches may find their small businesses increasingly under threat. At the same time, people may be discouraged from becoming Medifast coaches in the first place (especially if oral weight loss therapies become available).
Conclusion - Why I Will Not (Yet) Buy MED Stock Despite The Compelling Valuation
Medifast looks like a wonderful company at its core. It is solidly profitable, generates high excess returns on invested capital, and does not require large maintenance capex (long-term average 1.2% of sales). Admittedly, it is a cyclical business, but at the same time, it has relatively low operating leverage. This is currently reflected in a still solid profitability despite a sharp decline in sales. In addition, Medifast is conservatively financed and has no interest-bearing financial debt apart from $22 million in lease obligations. The company's liquidity position is strong and the dividend seems reasonably secure from a cash flow perspective (payout ratio of around 50% in terms of 2022 free cash flow).
However, I would not over-interpret the safety of the dividend given what is undoubtedly a very difficult environment. The increasing availability of weight loss drugs could ultimately render Medifast's core business obsolete - and who wants to own a company that sells low-margin weight loss drugs that I am convinced will eventually become commoditized given the significant research in this area? I frankly doubt that a combination of Medifast's core model, with its emphasis on the coach-client relationship, and marketing incretin mimetics to the same customers can work satisfactorily.
Furthermore, despite the long-term incentives, I think it is likely that management is coping with the current environment by cutting back on its most important asset - the coaches. Against this backdrop, I find it questionable that the company apparently no longer discloses coach compensation in its annual report. The decline in estimated coach compensation is worrying, as is the sharp drop in the number of active coaches. In my view, the latter is likely due not only to weaker expected compensation or demand for a better-paying occupation (aside from those just looking to supplement their regular income) but also likely due to perceived "competition" from weight loss drugs that may make it appear increasingly unrewarding to become a Medifast coach in the first place.
With a blended price-to-earnings ratio of 6.5 (Figure 9) and a free cash flow yield of 17% (average 2020 to 2022) - and these valuations do not even take into account the company's net cash position - Mr. Market definitely doubts the future viability of Medifast's solidly profitable core business.
Figure 9: Medifast, Inc. (MED): FAST Graphs forecasting chart, based on adjusted operating earnings per share (FAST Graphs tool)
In my view, Mr. Market is correct in his assessment of MED stock, and I personally do not consider it a good addition to my portfolio. That said, I continue to keep an eye on Medifast's operations, particularly the coaches and their estimated compensation, for possible signs of stabilization or a turnaround, as I'm not (yet) entirely convinced that incretin mimetics like semaglutide or tirzepatide (or future oral variants) will render Medifast's core business obsolete.
Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there's anything I should improve or expand on in future articles, drop me a line as well. As always, please consider this article only as a first step in your own due diligence.
For further details see:
Medifast: Unveiling A Challenge Beyond Weight Loss Drugs