Executive Summary:

I am recommending a long investment in MED.  I believe investors are not recognizing crucial differences between MED's Take Shape for Life (TSFL) business and other more controversial MLM businesses (i.e. HLF, USNA, NUS).  If one can get comfortable with TSFL, it becomes clear that there are multiple ways to win with this investment:

• Sustainable high free cash flows with room to grow
• New integrated compensation plan should drive growth in health coaches
• Continued re-franchising of MWCC optimizes profitability
  • Overly conservative balance sheet with potential to significantly improve capital allocation
  • Debt free with over $68M of cash
    • Most recent activist/potential acquirer should be willing to pay a significant premium in order to utilize its $2Bn in NOLs
    • Engaged Capital filed a SC 13D  in May that outlined their long thesis.  This was followed by another SC 13D filed at the end of August by ModusLink Global, a company controlled by Steel Partners' Warren Lichtenstein

Strength and legitimacy of the TSFL business and sustainability of its cash flows

Understanding the differences between the TSFL business and other more controversial MLMs is key.  So we must address the widely disseminated HLF short thesis and those who mistakenly assume all MLM businesses are created equal.

The direct selling/network marketing/MLM model, when done right, can be a sustainable, highly cash generative, and capital light business.  When done wrong, as a pyramid scheme, the business can exhibit the same characteristics for time and appear even more attractive due to rapid top line growth but must eventually collapse on itself by definition as there will be no one left to scam at the bottom. 

Multi-level marketing model does not present material risk. Unlike other direct sales models, the Issuer’s health coaches do not hold or distribute inventory. Product is shipped directly from the Issuer to the end customer and health coaches do not receive a commission on products they purchase for personal consumption.  Further, sales to coaches for personal consumption comprise only approximately 6% of the Issuer’s total revenues. - Engaged Capital SC 13D

MED does not exhibit the characteristic "Pop and Drop" of alleged pyramid schemes, rather it experienced a "Pop" from 1,850 active health coaches at YE2007 to 9,600 at YE2011 and has plateaued for the last few years:

Compare this against slides 248-257 in Pershing's HLF December 2012 presentation

Legitimate direct selling businesses can seem like pyramids when they grow quickly but they don't NEED to grow because they aren't deriving their profits from recruitment but rather from sales of the end product.  The "Pop" is simply due to the effects of a larger and larger networked sales force and the limiting factor becomes the end market for its product which in MED's case would be overweight/obese people (don't think anyone would argue that we need to worry about end market for obesity in America).

Although pyramid schemes don't typically stall out, this by itself obviously doesn't prove anything as MED might still be a pyramid scheme and maybe it's just not growing as quickly as HLF so it hasn't yet experienced the drop.

Another characteristic of pyramid schemes is that the product is bundled with the business opportunity.  This may be the simplest proof as MED sells its product through 2 other main channels, Medifast Direct and MWCC, both of which has had to compete against non-direct selling competitors like Nutrisystem, Weight Watchers, Jenny Craig, etc. for years.  This is the most straight-forward defense against MED critics who need to understand that the crux is the efficacy of the product itself the question is whether it's good enough and actually bought when placed side by side with comparable products at similar price points and NOT pushed by a HC/distributor who earns commissions or is incentivized to recruit you into the scheme.  This point must be stressed - the fact that the product can and has competed against NTRI is huge.

No sane unbiased person would buy HLF Formula 1 at a 65% to 226% premium to Ensure, Slimfast, or Lean Shake or HLF multivitamins and supplements at ~200% premium to comps unless they were also being sold on the business opportunity whereas the $339 Medifast Package compares favorably with the $425 Nutrisystem Core Package (with Auto Delivery Discounts: MED $254.25 vs. NTRI $279.99).

Indeed, one of the main reasons for the plateau in top line growth is the lack of recruitment, training, and development of new Health Coaches which is partly why MED rolled out its new "Integrated Compensation Plan" in September last year.  HLF touts that "after build up phase you continue to receive income even when you don't work yourself."  This is in direct contrast to MED's plan which is structured so that HCs must consistently sell product to be paid.  A global director I spoke with who had been with TSFL for nearly 10 years continues to directly sell product and support clients in addition to training and developing other HCs and claimed to have directly supported 5000 clients and developed/recruited 500 coaches in his 10 years with TSFL.

Other differences between TSFL and HLF

• TSFL's top 1% of HCs makes ~30% of total commissions paid out vs. HLF's top 1% of distributors taking ~88% of total commissions paid out
• The depth to which HCs are compensated on their down line is capped at 6 generations vs. an "infinitely deep" down line for HLF distributors
• TSFL payout (commission) is up to 31% (42% with max bonus) vs. HLF at 73%

Finally we can look to the FTC's website:

• Do distributors sell more product to other distributors than they do to the public?
• No, any sale to a sponsored HC is by definition going to be used by that HC as a public client
  • Does the amount of money distributors make depend more on recruiting (that is getting new distributors to pay for the right to participate in the plan)?
  • No, HCs are not compensated for simply recruiting HCs - compensation is structured to drive end sales to end clients
    • Does the money made depend mostly on selling to other distributors than on sales of the product to the public?
    • No, the only way to make money is by driving end sales even if it's in the context of helping HCs below you

Does MED Have a Competitive Advantage?

The stock trades at a ~40% discount to peers. Currently, the Issuer trades at 6.7x consensus 2014 EBITDA estimates, a 47% and 38% discount to weight loss peers Nutrisystem and Weight Watchers which trade at 12.6x and 10.8x, respectively, despite having what the Reporting Persons believe to be a superior operating model. - Engaged Capital SC 13D

Disregarding the valuation discount to peers for now, let's focus on the claim that MED has a competitive advantage in the form of a superior operating model to both NTRI and WTW.

Compared to NTRI

I agree that MED has a superior operating model to its most direct product competitor NTRI.  EC's SC 13D cites MED's 75% gross margins and more flexible cost structure that is "comprised of variable commissions and advertising expenses" providing "financial flexibility and downside protection."  This is evident by MED's more consistent operating margins and FCF over time.  

Is the "product" differentiated?

If the product is the food by itself then no I don't believe it to be meaningfully advantaged - each customer's personal preference will dictate their opinion on taste and different online message boards and forums had varying views without a clear preference of one over the other.  This actually explains why Medifast Direct is struggling as it must compete against NTRI, who has greater brand recognition, solely on the basis of its product and marketing efficacy.

The same goes for the direct selling aspect - TSFL HCs are not inherently more or less motivated to succeed than HLF or USNA distributors. 

However, I believe TSFL does have a differentiated and sustainable competitive advantage due to the combination of the product and incentive structure of the personalized health coaching service.  The TSFL health coach is much more highly incentivized to see the client succeed and become a walking billboard/referral source vs. NTRI's corporate counselors.  And TSFL is differentiated from alleged pyramid schemes, HLF and USANA, in the sense that it is sustainable due to the structure of the compensation being focused on actually selling an end product that should produce noticeable results vs. pyramid recruiting additional distributors and loading them up with overpriced shakes and multivitamins.

When you think about it, a complete weight loss/management program like Medifast or Nutrisystem is an ideal product for direct selling because dieting is hard and people need the accountability and support of others who have been through the process, want to see you succeed, and can teach you healthier eating habits (reasons why the WTW model has been so successful).

This is entirely different than the rationale for USNA/HLF shakes (not a sustainable weight loss method as no one wants to drink shakes forever) and multivitamins (multiple studies questioning the benefits of most supplements: http://www.webmd.com/vitamins-and-supplements/news/20131216/experts-dont-waste-your-money-on-multivitamins) which HAVE to be pushed by distributors because no one would actually buy the overpriced products otherwise. 

Compared to WTW

It's hard to say whether MED has a superior operating model or competitive advantage against WTW's traditional group meetings business as it historically has had an amazing brand and moat with dominant market share but that's OK since it also caters to different population than your typical NTRI/MED customer who isn't looking to count calories or track points.  In addition, after taking into account the concerns around WTW's internet business and the steady decline in group meeting attendance over the past 7 years (discussed in the WTW thread), I do agree with EC's point that "TSFL’s direct sales model should result in lower customer churn and less volatility than other weight loss business models (e.g. group meetings, e-commerce, mobile apps)."

Growth Opportunity in TSFL

The Issuer has an opportunity to significantly increase organic growth rates in its largest distribution channel, Take Shape for Life (“TSFL”). The Reporting Persons believe there is significant potential to grow the TSFL network by adding thousands of additional health coaches in new geographic regions within the United States. The Reporting Persons believe the Company’s penetration of the market is significantly below its peers and an enhanced focus in this area will have a material impact on accelerating the Company’s growth.  TSFL has only ~11,000 active health coaches compared to other multi-level marketing businesses with much larger networks. For example, for the first quarter of 2014, Herbalife had over 70,000 average active sales leaders in North America while USANA had over 80,000 active associates in the Americas and Europe. Further, TSFL’s direct sales model should result in lower customer churn and less volatility than other weight loss business models (e.g. group meetings, e-commerce, mobile apps). - Engaged Capital SC 13D

I agree that there is significant growth potential but I don't think the number of HLF and USNA distributors is a great proxy (not that I have a better one) for steady state HC potential.  I also don't believe the historical growth rate of HLF/USNA distributors is very relevant to HC's growth rate potential either due to reasons discussed above. 

However, I am optimistic that the new Integrated Compensation Plan will promote HC growth.  To understand why we must look at the changes implemented in the new plan.  Management came to realize that the plateau in HCs in recent years was because they were not properly incentivizing existing HCs to develop new HCs to sell product.  Previously, commissions were not based off of straight sales but rather off of volume - there were also different commissions for different products and recruiting bonuses were paid in such a way that health coaches could maintain their income by relying on previously recruited health coach productivity (to be clear they still weren't be paid to recruit health coaches but HCs could in a sense game the system and maintain their commissions if their previously recruited health coaches were still end product).  The recent change simplified the commission calculation by making it directly proportional to actual end retail sales rather than volume and changed the recruiting bonuses structure - thereby only rewarding HCs who were either actively selling product /supporting customers or developing HCs who were selling product/supporting customers.  HCs must now be more aggressive in growing their business to maintain and grow their commissions.  This is a win win for MED as it will spur end sales and HC growth and save commission money or at least redirect commissions to HCs that are actually growing their business.

Management believes the changes made to the TSFL compensation plan in 2013 will reduce commissions by 2% and increase annual EBITDA by $4-$5 million. - Engaged Capital SC 13D

A global director  HC I spoke with said that for HCs who were consistently selling product/supporting clients the change just made it "easier to understand for health coaches" and that Medifast just "wants to see growth in coaches so that more people can benefit."  To be clear, Health coaches still do NOT earn commission or bonuses for simply recruiting other Health coaches and no commissions are earned on start up materials that new coaches buy at cost from MED.

Still, even with this change it's unreasonable to expect HLF/USNA growth rates as many TSFL customers are actually interested in using the product to lose weight and may not necessarily be interested in becoming a health coach themselves.  And in my experience, the TSFL HCs goal really was to support healthy habits and weight loss - the business opportunity was just an added bonus for those who felt the program worked for them and wanted to share their successful experience and not a get rich quick scheme.  I even tried baiting him into talking about blue sky scenarios of making millions but he was very grounded and said that the focus is simply on helping people succeed in their goals and if you do that right then the business will naturally spread through referrals or customers wanting to become a health coach as well. 

There is also international growth potential as TSFL is also in the early stages of expanding into Mexico and Canada.  Ultimately, I think what's important at this valuation is that FCF is sustainable, market penetration is low, and there are multiple ways to win.

Medifast Direct and MWCC

I chose not to focus the write up on Medifast Direct or MWCC as both will gradually become a smaller part of the business and I don’t believe they are core to the current investment thesis.  Recent management improvements in the businesses were summarized in Engaged Capital's SC 13D:

• Management is in the process of employing short- and medium-term levers to improve Company performance.
• Efforts underway to franchise the under-performing corporate-owned Medifast Weight Control Centers (“MWCC”) could drive an estimated $5-$10 million increase in earnings.
• Management believes the changes made to the TSFL compensation plan in 2013 will reduce commissions by 2% and increase annual EBITDA by $4-$5 million.
• Growth in the MWCC business is economically attractive and “capital light.” The Issuer is targeting 250 franchised MWCC locations, as compared to only 41 [51 corporate and 74 franchised as of Q2] at the end of 2013.
  • New management team continues to make positive changes. The Issuer’s relatively new management team has, to date, made numerous positive changes to “professionalize” the business, including the recruitment of new management talent and a renewed focus on profitable growth and return on invested capital. The Reporting Persons believe this process is still in early stages and if it continues within both the management ranks and the Board, it has the potential to drive significant shareholder value as the business continues to grow and mature.

Activist Opportunity

Notable Events:

The company is ripe for activism from a corporate governance perspective as the board is staggered and comprised of 12 directors (unnecessarily large for a company of its size) of which only 9 are independent.  The role of CEO and Chairman is combined and there are multiple directors with questionable relevant experience.  Also 72% of votes cast at the 2014 annual meeting were against the levels of NEO compensation.  This compares very unfavorably to its peers:

• Nutrisystem: 8 directors - all with relevant experience - 7 independent - separate CEO and Chairman - 97% approval of NEO Comp
• USANA: 5 directors - all with relevant experience - 4 independent - separate CEO and Chariman - nearly 100% approval of NEO Comp
• HLF - heavily influenced by Icahn and affiliates
• WTW - controlled by Artal Group
• NATR - 5 directors - 1 each from activist hedge funds Red Mountain and Prescott Group

MLNK/Steel Partner's History and Intentions

ModusLink raised $100M of 5.25% Convertible Senior Notes due 2019 in March with the explicit intention to "use the net proceeds from the offering for general corporate purposes, which may include potential acquisitions and other strategic business opportunities."  Steel Partners Warren Lichtenstein is Chairman of MLNK and has an ownership stake of over 27% in MLNK and has previously stated that the MLNK's "most valuable asset [is] its NOLs" and his goal with MLNK is to "utilize ModusLink’s approximately $2.0 billion of federal net operating loss carryforwards (“NOLs”) as quickly as possible. We are looking to grow ModusLink through acquisitions."  MLNK also has $450.9 million in state tax benefits and $60.1 million in foreign tax benefits.  The federal NOLs could offset MED's ~$12MM per year in taxes or ~$0.93/share and boost FCF by nearly 50%. 

It seems clear that Lichtenstein is setting up to take a run at acquiring MED.  The board obviously thought so too and promptly adopted a poison pill. 

Lichtenstein actually recently employed a similar tactic to gain control of MLNK whereby he used HNH cash (Handy & Harman - another company controlled by Steel Partners) along with Steel Partner affiliated funds to establish a 10% position in MLNK.  MLNK's board at the time was also staggered and populated by an entrenched board of directors who also adopted a poison pill.  The saga of his battle to eventually gain control is summarized below:

The protracted battle with MLNK demonstrates that Steel Partners resolve and persistence was eventually able to overcome a poison pill and a staggered board. 

According to Q2 13F filings, the top 5 holders controlled 40.8% of the company and the top ten controlled nearly 60%.  Still, a paper put out by the National Bureau of Economic Research stated that it found that "an effective staggered board nearly doubles the likelihood of remaining independent, from 34 percent to 61 percent."  Air Products failed attempt to acquire Airgas at 67% premium in 2010/2011 despite successfully appointing three Air Products nominated directors to the board further demonstrated the power of a poison pill combined with a staggered board.

Valuation

So the relevant questions are:

• What should MLNK be willing to offer to acquire MED?
• Will the Board act rationally and in the best interest of shareholders?
• What is MED worth on a standalone basis if the Lichtenstein's takeover attempt is unsuccessful?

MLNK should be willing to offer a premium to acquire MED's FCF stream as it would be an ideal vehicle to utilize MLNK's NOLs and would also provide MLNK with ample cash to pursue Lichtenstein's goal of growing MLNK through acquisitions.

Unfortunately, the composition of the board along with the founding family's attachment to the company suggest that MED will not give up control of the company without a fight.  According to an article in the Baltimore SmartCEO magazine, it was literally the former founder, chairman, and CEO's dying wish that his brother, the current Chairman and CEO take over the company and groom his daughter, the current President/ COO/board member to take on more leadership in the company. 

"My role with Meg is taking her from being a strong, functional manager to being a leader, strategically in the business and helping her develop her financial skills to the point that she could do what her father and I are capable of doing.” - CEO/Chairman Michael MacDonald

"For my dad, Medifast was something he believed so strongly in, [and] knowing his brother, a tremendous businessman, would come in and keep it going, made his last few months on earth easier.  He knew they shared the same ethics, morals and values. If my dad was scared of anything, it was that someone would come in to the company and tear apart the culture he built. That would have devastated him … my father was more comfortable letting go of life knowing that was taken care of.” - COO/President/Director Margaret Macdonald Sheetz 

*Management has privately commented that they would be open to selling and claim to have engaged an investment bank to look into it.  However, I also spoke with one of MED’s largest shareholders and they were skeptical that the family would so easily give up control.

So in the scenario that the entrenched and staggered Board is irrational and refuses to give up control, there is always the chance that even a generous offer is rejected and activists don't have the patience or resources to wage a protracted proxy battle to overhaul a staggered board.  In that case, what would MED be worth on a standalone basis?

The stock trades at a ~40% discount to peers. Currently, the Issuer trades at 6.7x consensus 2014 EBITDA estimates, a 47% and 38% discount to weight loss peers Nutrisystem and Weight Watchers which trade at 12.6x and 10.8x, respectively, despite having what the Reporting Persons believe to be a superior operating model.  -Engaged Capital May SC13D

Current Multiples:

• MED: 8x
• NTRI: 11.7x (46% premium)
• WTW: 10.5x (31%  premium)

The above assumes cash sits idly on the balance sheet. 

The Issuer has a strong balance sheet with ~20% of its market cap in cash and no debt. The Reporting Persons believe the Issuer maintains excess liquidity and is evaluating various options for use of this excess capital.  The Reporting Persons believe the Company must adopt a disciplined, “return-on-capital”-focused allocation process to ensure that capital is allocated to its highest and best risk-adjusted use, either through organic investments, acquisitions, or returned to shareholders through share repurchases and/or dividends.  -Engaged Capital SC13D

Realistically, management would need to proactively justify rejecting MLNK's offer by aggressively deploying excess cash on the balance sheet to repurchase shares (MED repurchased 451K shares for $14.2M at an average cost of $31.49/share in Q2).

Risks and Mitigants

• MLNK unable to secure attractive financing to complete a potential transaction
• Artal was able to secure ~$500M against its ~$240M in equity for its LBO of WTW in 1999
  • Granted MED has a weaker brand/model relative to WTW back then, but today's historically low interest rate environment should allow for a better rate than back then as well (13% on Senior Sub Notes)
  • WTW PF adj. unlevered FCF 24.1M, adj. EBITDA 95.3, cash interest 55.4, taxes 13.3, capex 2.5
  • HLF issued $1Bn 5Y convertible notes in Feb at 2% (conversion price 25% premium)
    • BOD is irrational and prioritizes the founding family's interests over shareholders
    • Highly concentrated ownership and aggressive and persistent activist
      • Market perception that all MLMs are the same persists and depresses valuation
      • Sustainable and growing FCF combined with share repurchases
        • Public perception that all MLMs are the same hampers health coach growth and recent declines in HCs continue (Q2E 10,800 vs 11,800 year ago)
        • July coach numbers reversed and were increasing per Q2 call
        • Better recruitment education to stress differences and continued client success with the product
        • "Even if it is a scam, I still lost 95 pounds in 8 months so who cares? You can sit back and be stubborn all you want but at the end of the day I'm still skinny." -Health Coach Kristina Ray responding to critics suspicious of "Medifast Scam"
        • Opportunity for new leadership as the EVP of the TSFL division resigned in August
          • Failure to restart topline growth (guiding for a return to growth in Q4)
          • Realigned management to "provide a more aggressive focus on revenue growth" (shift from prior Q1 focus on profitability)
          • New initiatives to drive coach (BeSlim and virtual coaching videos) and client growth (Medifast Advantage)
          • 40%+ increase in 2H14 ad spend plus new ad agency/campaign, 30 new products for 2014
          • New VP of Direct Response focused on customer acquisition and retention
            • Increased competitive pressure from Nutrisystem - CEO Dawn Zier brought in to turnaround business in Nov 2012
            • If management stumbles, board may be forced to succumb to shareholders who will have even more reasons to demand bigger changes at the management/board and be more open to strategic alternatives
              • Continued weakness in MWCC's weight loss center industry which has experienced 10% YoY declines for several years
              • Pace of MWCC refranchising is ahead of schedule
              • Early encouraging results from new lower commitment Fit for Four program