Description

Investment Thesis: Medifast (MED) is a health and wellness weight loss company that markets its products via a coaching model through the Optavia brand. It is a high growth, strong free cash flow conversion company, offering an attractive near-term and long-term (5 year+) investment opportunity. There are 4 key components driving returns for Medifast investors over the next 5 years. Firstly, sales should grow at a 15% annualized rate. Secondly, EBIT margins should expand back to their historical 15% rate, providing a roughly 20% tailwind to net income over the next 5 years. Thirdly, Medifast requires little to no incremental capital to grow and has a highly variable cost structure - making it a great name to own in today’s environment.  We believe this will allow them to return roughly 10% of the market cap (at today’s prices) to investors on an annualized basis. Lastly, the multiple should expand from 7x 2023 earnings estimates to its historical range of 20x NTM PE, which it has averaged for the last 5 years.  Ultimately, we think Medifast offers investors an asymmetric risk-reward opportunity over the next 5 years.

In the shorter term, highly correlated alternative data sources, shown below, suggest the recent softness in the business was temporary. Sales have rebounded and imply a ~14% Q3 revenue beat (and likely a greater EPS beat) relative to significantly reduced consensus expectations. While consensus revenue & EPS expectations are well below management guidance for FY22, our numbers are on the upper range of management’s guidance. We believe the upcoming Q3 beat & raise will be a catalyst to improve investor confidence and illustrate resumption of growth and a re-rating of the multiple back closer to historical levels. Additionally, we believe there will be margin expansion next year as price increases and adjustments to the new inflationary environment lead MED back to historical gross and EBIT margins. Furthermore, this should lead to significant EPS growth in FY23 where we are projecting $17/share vs consensus at $13.36 for next year. At the historical peer group average P/E of 16x (well below MED’s long term average), MED shares could trade at $272/share or 130% upside from today’s levels in the next 12 months. Longer term, we think the company will grow earnings at 20%+ growth off of the $13-$14/share forecasted for this year.  Over the coming 5 years, we think MED can earn $30.00+ share and trade at 15-20x earnings. This equates to a $450-$600 stock inclusive of a 5% dividend yield.  Overall, we have reasonable confidence that MED can generate a 35%-43% IRR in this time frame.

Below is a chart of our data and estimates:

The table above conveys our data and how accurate it is in predicting MED’s revenues relative to consensus over time. The first line, labeled “data”, is what our data was predicting for the quarter. The second line is what the reported revenue was on a year over year basis. The line labeled “differential” is the delta between the company-reported revenue and our data. The differential has consistently been between 3% and 7%. For Q3, we are projecting -1.9% for the quarter using a 3.4% positive differential, which beats consensus revenue expectations by 13.9%. The narrow differential range, coupled with a 99% correlation between our data and revenue metrics, gives us a high degree of certainty that we are predicting this inflection in the business correctly. Our data sets began to see a notable negative inflection in MED's revenue growth trends in June/July. This was ahead of the Q2 report on August 3rd, which led us to believe Q3 consensus estimates were at risk and to subsequently take a cautious stance on the stock. The sell side (understandably) felt blindsided with the Q2 release and was thus worried about the trends in MED’s business. We think this will change once they see the business has normalized and is now beating management’s conservative expectations. 

A Differentiated, Scalable, and High Cash Flow DTC Business Model: Medifast is a health and wellness weight loss company that markets its products via a coaching model through the Optavia brand. Through its network of coaches, Optavia offers customers a diverse array of meal replacement plans and products structured around a lifestyle change, with the intent of inducing weight loss and more healthy living. Coaches focus on helping their customers develop healthier habits - healthy eating, healthy exercise, healthy sleep, and healthy hydration. One thing we noticed from the coaches we spoke to was a sense of pride in being associated with Optavia. Coaches typically start off as customers, having lost weight and become healthier through using the product themselves. They view Optavia as very beneficial for their customers and positive for the world. This ethos creates a positive feedback loop where people are proud to be associated with and promote the brand. As a result, this has made Optavia prevalent among religious communities and social media. Optavia also has significant repeat business. Customers who try it often come back to the program several times. Currently, Optavia has a network of 68,000 coaches primarily located in the United States, with a growing presence in Asia (Singapore and Hong Kong established in 2019).

While, sometimes equated to the business models of Herbalife Nutrition (NYSE:HLF) and other multi-level marketing (MLM) strategies, Medifast is really a DTC (direct-to-consumer) company that approaches the sales and distribution process in a differentiated manner that avoids incentivizing predatory behavior from their coaches. All the Optavia coaches we spoke to talked about helping people as a primary motivator and how fulfilling their jobs are. One of the more successful coaches we spoke with was a nurse practitioner, but was making more money and felt more fulfilled coaching people with Optavia. She started as an Optavia customer initially, lost 52 lbs. and finally moved to being an Optavia coach. She is now making a six-figure commission salary while working 20-30 hours a week doing something she loves. Optavia coaches do not hold product themselves to resell to customers. Instead, they direct customers to purchase their products through MED’s centralized platform; this prevents the exploitative markups and pricing schemes that have given the industry a negative reputation. The differences in MED’s DTC business model compared with MLM companies is highlighted in the chart below:

Source: Medifast investor presentation

Further, this helps Optavia coaches form more durable relationships with their clients to build community, provide guidance, and instill healthier habits. These practices led to MED being recognized by Forbes as one of its 100 Most Trustworthy Companies in 2016 and 2017.

 An easy analogy to help one understand the business model is that the clients are the fuel and the coaches are the engine of growth that share a symbiotic relationship. Selective customers are invited to become coaches, who then recruit new customers into the program. The multiplier effect has catapulted the growth of the overall customer base. This has led the company to be the fastest growing major wellness program over the last few years.

Source: Medifast investor presentation

Since the coach-centric program was rolled out in 2017, the number of active coaches has grown by ~350% with a CAGR of over 40%. 

Source: Medifast

A major driver behind the rapid growth in coaches and a competitive advantage is that the coaches typically earn more money participating in this program relative to other competitive offerings. For example, in 2021, Optavia coaches earned on average $26,210 (with some top performers earning over $100k), which is 75% greater than the $14,978 average that Herbalife’s North American sales leaders earned. Additionally, given increased commission rates, Optavia coaches have seen their commissions grow by nearly 42% on average over the last five years. This indicates that the Medifast model has only become increasingly lucrative for coaches over time. 

Source: Medifast

The recent roll-out of a mobile app for coaches, should enable MED’s coaches to more efficiently communicate with and grow their base of clients.  As a result, further increasing their income potential and generating greater revenues for MED. The following are comments from an expert call with a high-tier Optavia coach from earlier this year which highlights the opportunity for further increases to MED’s overall revenue per coach:

“I definitely want to grow my business. I mean I guess just to put it in sort of concrete terms, I'm making about $5,000 a month now. And I don't see any reason why I couldn't double that in the next year or two. And I certainly have mentors that are making five times that in terms of numbers.”

MED has a scalable, asset-light business model. The company manufactures its powder-based products in its own facilities domestically and outsources manufacturing of other meal products.  The facilities have the current capacity to support revenues of about $2.5 billion (vs ttm revenues of $1.66 billion). Gross margins have consistently been in the mid 70% range, although recently they have temporarily declined to the lower 70% range due to increased supply chain costs and a greater percent of outsourced manufacturing. As illustrated below, internal operating costs excluding commissions to the company’s coaches have started to scale down over time.

Source: Medifast

Medifast does not need to finance a salesforce since its coaches handle their own marketing and outreach, which enhances its profitability. This has led to gradual operating margin expansion over time. Management targets a 15% operating margin and has used some of the increased margins to help fuel growth in the number of coaches by increasing commissions from about 39% of revenues to 44%. Despite this, operating margins have increased from about 10% in FY16, before the focus on the coach centric model was implemented to over 14% currently.

A Track Record of Rapid Growth Underscores the Success of the Product and Acceptance of the Company’s Coach-Centric Wellness Model: While management has targeted a 15% revenue CAGR over the last few years, they have significantly exceeded this metric. As illustrated below, during the period from FY16 to FY21 MED’s revenues grew at a CAGR of over 40%. 

Source: Medifast

This implies that MED has taken considerable market share in the weight loss/wellness industry over the last few years. During the same period, owing to the scaling of the company’s business model, EPS has grown at an even faster pace, with a CAGR of 56%.

Source: Medifast

This rapid growth in revenues and profitability is a testament to the success of the Optavia product and acceptance of the company’s coach-centric wellness model.

Historically, due to its high margins and asset-light business model, the company generates a strong amount of free cash flow annually and requires minimal growth capital. FY21 was an investment year due to spending on supply chain (new distribution & warehouse facilities in Texas and Maryland), technology (new mobile apps for coaches and customers) as well as an intentional build-up in inventories to address stock outages in certain SKU’s. Historically cap-ex runs approximately 1% of revenues and FCF conversion has averaged 10%-15% of revenues. As a result of the company’s strong free cash flow, MED has a rock-solid balance sheet with a positive net debt/cash position. The strong free cash flow has been returned to shareholders via a growing dividend (see below), which typically averaged about 60% of cash flow with a current yield of 5.5% and share buy-backs.

Source: Medifast

With FY21 cap-ex and inventory investments now returning to historical levels, we believe future dividend increases will increase commensurate with growth in net income. This in turn will enhance total shareholder returns.

Multiple Drivers of a 15% Revenue CAGR Include: An Untapped Domestic TAM, International Expansion, New Products, and a Subscription Model for New Apps:  Looking forward, management is targeting a revenue growth CAGR of 15% and 15% operating margins. We believe this growth trajectory is realistic and points to a number of factors that should aid future growth. With ~90% of customers on continuity shipments and ~77% repeat sales, this adds a degree of predictability and stability to revenues. With the roll out of new coach and client digital apps, it is likely that coaches will be able to take on more clients. As a result, MED’s revenue per coach will continue to rise. Management has stated that they are evaluating a subscription service for both coaches and client apps, which could provide a high margin recurring revenue opportunity.

What should give investors confidence in the long-term growth in domestic revenues is the fact that the overall TAM of the domestic wellness market is large relative to MED’s size. Additionally, the population who are both overweight, want to lose weight and would consider paid meal plans as an option. Given the white space opportunity in the ~$7 billion domestic TAM, the success the company has had with its coach-centric model and the market share gains, we still believe there is significant growth potential for MED in the domestic market.

Source: Medifast investor presentation

Regarding new growth opportunities, it is possible that MED will add a hydration product to its customer wellness offering. Our discussions with some Optavia coaches suggested it could be well received.

However, the biggest incremental opportunity for MED over the next 3-5 years will come from international expansion. The fact that Herbalife derives 76% of TTM revenues from international markets while beauty & wellness supplier Nu Skin Enterprises (NYSE:NUS) gets 80% of revenues from international markets, underscores the large potential opportunity for MED to fuel incremental growth for a number of years. 

The leading two opportunities for international expansion for MED are in Asia and with Spanish speaking customers. We have already seen MED begin to explore international expansion opportunities with its entrance into Asia via Singapore and Hong Kong in 2019. With Hong Kong opening up at the end of September this could provide a catalyst for their Asia business to start expanding more rapidly. These cities are typically used as springboards for expansion throughout Asia; however, with COVID causing economic shutdowns, this expansion was temporarily stalled. As Asia begins to re-open post COVID, we believe MED management will refocus on this region for new growth opportunities. 

Given the large percent of business that companies like Herbalife & Nu Skin derive from Asia, we believe this is a natural market expansion opportunity with significant revenue potential for MED. In terms of other international markets, Medifast management is currently laying the groundwork for expansion into Spanish-speaking communities, which we believe will be used as a catalyst for their eventual expansion into Mexico as well as South and Central America. Shortly, all of its documentation will be converted into Spanish and many of the company’s Spanish speaking coaches are reaching out to people in their network in some of these regions. As Spanish speaking countries represent roughly 15% of Herbalife’s revenue, this provides a window of opportunity for MED. Longer-term, we believe MED’s geographic profile will look closer to that of Herbalife, with North America, Asia and ROW accounting for about one-third of revenues.

Highly Correlated Data Sources Show Recent Slowing of Demand Was Only Temporary and Has Rebounded Leading to the Likelihood of a Q3 Revenue Beat: With the announcement of Q2 results (in-line revenues and a EPS beat), management surprised investors by reducing its FY22 revenue and EPS guidance by ~10% and 12.5% respectively at the midpoints. They cited, “macroeconomic factors such as inflation and consumer sentiment which have impacted customer retention”. Management indicated that while a Q2 customer acquisition program had been a success in adding new customers, they saw a sudden softening in retention in the later part of Q2 across all customer cohorts (not just new customers from the acquisition program). The company’s survey of clients and coaches showed that while customer satisfaction recorded a new high in June, inflation issues were the primary issue mentioned by customers behind lower retention. The reduced FY22 guidance was a surprise to most investors, in that the company has been reporting a consistent string of above consensus revenue growth dating back at least to FY19. For that reason, the share price of MED dropped and has continued to fall with the recent general market weakness. Currently, the stock is trading off about 45% from its earlier 2022 highs.

We had been monitoring alternative data for MED from two sources. Our analysis of the data sets began to show a softening in MED’s business beginning late in June and decelerating further in July. The forecast our data was showing implied Q3 revenues in July were trending well below consensus, which led us to sell our position prior to the Q2 report. We correctly predicted the downturn in the shares that occurred leading into the Q2 earnings release, and we believe we are correct in predicting the recovery in the shares that should occur with the next earnings release.

With Q3 and FY22 consensus revenues now significantly lower post the Q2 results, we began to see an improvement in the data correlated to MED’s revenues, especially relative to new lowered consensus. The improvement relative to new consensus began in August and has continued into September. The data for Q3 revenues vs consensus has accelerated from -14% in the month of July to ~+14% thru the end of September. Our model suggests that such a Q3 revenue beat would translate into EPS coming in at least 15%-20% above consensus forecasts. In the company’s presentation at the Jefferies online conference in September, they mentioned having begun to see improvement in their retention curves in August, consistent with the trends in the data we are seeing. 

Since only 2 sell-side brokers cover the company, we believe it is underfollowed and few people have noticed the significant improvement in the business relative to expectations. Also, following the lowered guidance and comments on the August 3rd call, one of the brokers downgraded the stock and appears to have adopted a bearish attitude by questioning the achievability and risk of management’s new earnings forecast. Moreover, the analyst has reduced their firm's FY22 EPS estimate 12% below the low end of the company’s guidance and is forecasting a decline in FY23 revenues. Thus, overall FY22 EPS consensus is now $11.95, which is below management's recently lowered guidance of $12.70-$14.10.  As of late, there has been a large negative shift in investment sentiment, which provides a great setup for the potential Q3 beat.

Upside to Q3 financial results would signal to investors that the slowdown was temporary and indeed likely due to the jump in inflation and gas prices (the latter has declined ~25% from highs) seen in Q2. Noteworthy, the significant rise in grocery food basket prices in the past 6-12 months does not offer MED’s customers much of a cheaper meal alternative. 

MED Coaches Confirm Our Data and Voice Optimism on Continued Growth: We contacted some of MED’s Optavia coaches to get their perspective on recent business trends and the future outlook. We heard that while they did see order and retention rates soften in the summer months, there are signs that business has picked up or at least stabilized with all coaches optimistic that growth in their individual business will resume. None of our discussions with MED coaches suggested any fundamental or systemic problems in the business. The following are some comments:

•  Speaking with a “global director” level Optavia coach with 75 coaches in his network, 1,500-2,000 clients and doing annual business with MED of $2.5-3.0 million, he did see the summer softness in his network, which was more pronounced than the normal seasonality in the business. He believes the softness was due to the combination of a number of factors including: many more people (clients & coaches) enjoying post-COVID travel over a more than normal extended period (and suspending the Optavia program during this time), the surge in inflation and a tough comparison with a year earlier when supply chain shortages caused over purchases to have extra product supply. He has seen a rebound in his business (“September was a great month” for him), has seen more people who had stopped the program returning and his coaches refocused/engaged, is optimistic his Q4 will be up from Q3 (despite normal seasonality pressures) and looks forward to the January beginning of the year traditional spike in demand. He believes the international expansion and Spanish speaking growth initiatives will be successful and thinks a hydration product could be well received.

• We spoke with another “global network” Optavia coach, a former nurse, with 57 coaches and 862 clients in her network after only about 2 years coaching, currently generating about $1.6 million in annual sales with MED. She said her business was growing thru 2022 and began to slow in the May-July time period, with things stabilizing at a higher level currently. She points to increased post COVID travel as a major reason for the weakness in her business and points out when people are traveling and enjoying themselves, they are not focused on their health. She is optimistic that the company and her business will grow after the current period, aided by international expansion opportunities and believes there is a good set-up for a “huge New Year’s” for people to refocus on their health.

• Another coach said that the “summer was definitely slower than normal”, “August was quite low”, “it’s coming back now”, “seeing an upward trend from August to October” in her network of coaches & clients September was up 11% and she is projecting that October (assuming no new clients) will be up another +10%. Regarding the reasons for the summer softness in her network, she pointed to more people in her network traveling post-pandemic and higher gas prices. 

To be clear, these anecdotal stories are not nearly as meaningful or relevant as the highly correlated data source, as they only represent a fraction of the business. In speaking with a number of MED’s Optavia coaches about why the program has been successful and different from other weight-loss programs they point to the product itself and the structure of the overall program as key differentiating factors. The coaches point to the proven nature of the product, diversity of food to fit a variety of tastes and that if a client stays on the program, they will achieve their weight loss goals. Coaches we spoke with point out that Optavia is not just a diet, like other programs, but a personal transformation program focused on mastering healthy habits focused on 23 elements of a healthy lifestyle, including diet, sleep, and hydration. Coaches point out that unlike other do it yourself, follow-the instructions, diet programs, Optavia clients are assisted and monitored by a coach & on-line community. One coach we spoke with said the key to the success of his clients in achieving their better health goals was “direct accountability“ to their coaches and having a community to support them, which is different from other diet programs. He noted further that the majority of his clients (as well as himself) have tried and been unsuccessful with other diet programs, with most achieving success with the Optavia program.

A Re-Acceleration in Growth Should Lead to a Re-Rating Higher, with Significant Near-Term and Long-Term Shareholder IRR Likely: We believe a Q3 revenue beat would help mitigate concerns relative to the impact of inflation on MED’s business.  In addition, it will likely re-establish MED as a growth company and lead to a re-rating of the multiple of the shares back to prior levels. Currently the shares of MED are trading at about 8.8x the mid-point of management's reduced FY22 EPS guidance of $12.70-$14.10. As illustrated in the below chart, this valuation is well below the company’s historical average from 2019 to present.

Source: Cap-iq

Catalyst

Earnings announcement for Q3 with beat and raise 

2023 earnings