Description

Medifast has been written up on the VIC before so I’m not going to rehash the company description but focus just on providing an update. Company’s stock price has come off its highs in recent months and some of the commentary this quarter around i) slowing growth in 2H21, ii) margin pressure due to inflation, and iii) an increase in inventories, which could signal product returns, caused the share price to drop down to ~$235 from its recent highs of $330 in May of 2021. I take a look at each of the risks and re-examine the growth potential of the business. In my downside case, Medifast could be a 2x return in 5 years while in my upside case, it could be a 3.5x return.

Given its decent growth (30% 5-year CAGR), decent profitability (+15% EBITDA margins), strong balance sheet (+$170M of net cash), strong capital return policy (4% yield from share repurchase and dividends), and large addressable market (Medifast has <5% of the market), Medifast is looking rather appetizing.

Aug 2021 Update

Medifast reported strong topline results as well as expansion in the gross margins. Revenues grew 79% to $394M representing 16% QoQ growth and gross margins expanded to 75% from 73% the previous quarter. Despite the strong quarter, the company also foreshadowed higher future COGS due to the use of co-manufacturing partners and indicated that inflation would negatively impact logistics and other spend. As such, though full-year revenue guidance was increased from $1.4-$1.475B to $1.425-$1.525B, EPS was held steady at $12.70 to $14.17 (compared to $12.69 to $14.14).

After closing, the stock traded down 9% from $287 to $260 and has since atrophied to $236. The stock is now trading at 1.8x 2Q21 annualized revenues and 10.5x 2Q21 annualized EBITDA. For a company with mid-teens EBITDA margins (17% in 2Q21) and +50% topline growth in 2021, that is an attractive valuation. The Company scores well on the Rule of 40 and I estimate that there is decent future growth in the coming years.

The $236 price is up 57% from the initial recommendation in Oct 2021 at $150. However, it is down 28% from the high of $330 reached in June this past year. Research analysts were overall positive on the quarter with price target increases from a couple of analysts. That being said, there were a couple of risks identified on the call that could be causing this selling. I will discuss each of these risks in turn.

-          2021 revenue guidance: Though revenue guidance was increased $25M on the low-end and $50M on the high-end, that means quarterly revenues in 2H21 are expected to be flat relative to 2Q21 revenues.

-          Inventory levels: inventories have increased significantly in the most recent quarter. Management claims it is increasing inventory to stay prepared to meet demand. Could be questions around returns of the product

-          Margins: Management mentioned that gross margins will come down in the near-term as they are working more with co-manufacturers to increases their supply. Management also flagged that inflation and logistics constraints are increasing costs as well. The net effect is that though revenue guidance was increased $25-$50M for the year, EPS was held steady.

-          Market Saturation: Not an overt question asked on the call, but worth thinking about if this company is to be a potential LT investment. Jefferies previously described the market opportunity as a $20B market. Worth examining in closer detail.

2021 Revenue Guidance

The company has generated $735M of revenues in 1H21 with 2Q21 revenues of $394M so the current guidance implies that the company will generate an average of $345M to $395M per quarter in 3Q and 4Q of this year. Forecasting can be a little tough as 4Q is usually a softer quarter given the holiday season and people taking a break from their diets.

Medifast’s business is fairly simple and is driven by i) the number of coaches and ii) the amount of revenues generated per coach. The pandemic really unleashed the model as people were locked at home and looking for supplemental income. Medifast allows coaches to make $26k a year on average which is a very good side hustle. The pandemic also caused people to get fat and with gyms being closed, people were looking for a way to shed their weight, another boon for Medifast.

The company revamped its model in 2017 and increased annual coach adds from 2,500 in 2017 to 9,100 in 2018. Another 7,700 coaches were added in 2019. Things got kicked into high gear in 2020 and 12,400 coaches were added in the year. 2021 has been off to a fantastic start with 7,800 coaches added in 1Q and 7,200 coaches added in 2Q. Revenue per coach has been steadily increasing over time from $22K in 2019 to $26K in 2Q21.

In our low case, I’m assuming 3,000 coach adds per quarter in the next two quarters and coach revenue declines to $24,000 on average. In such a case, Medifast generates $1.5B in 2021. If the company is able to perform at its recent clip and recruit another 6,000 coaches per quarter in 2H21 with coaches generating $26K in 3Q and $25K in 4Q. This would result in Medifast generating $1.6B for the year. The mid-point estimate in my case would be $1.55B, which exceeds the high-end guidance. In my low-case, the company comes in close to the higher-end of guidance. Note that Street Consensus as of Aug 12 has 2021 revenues at $1.51 so close to my low-case.  Note that estimating the number of coach additions is tricky since it seems that COVID has played a role here. That being said, I think that COVID’s effects may continue to persist in some fashion because i) a segment of the population will refuse the vaccination, ii) variants are sprouting up that continue to affect the population and iii) re-infection is a real phenomenon. At some point, I think society will find ways to adjust to the pandemic but the ability to earn +$20K as a side-hustle working from home will be attractive for many coaches. 

Looking at some of the charts below, the company has a strong history of increasing the number of coaches on its platform, which drives revenue growth.

Inventory Levels

One of the questions that was raised on the call was regarding the steep rise in inventory levels from $62M in 1Q to $$96M in 2Q. This inventory level is significantly higher than prior quarters stretching back to 2019 but if you look at inventory as a % of COGS, it isn’t such a dramatic departure. The company has typically operated with ~400 days of inventory and the dramatic surge in demand in 2020 caused inventory days to drop since 2Q20 to ~250 days. The increase in inventory thus brings inventory to a similar level with prior history.

It is also worth noting that the Company is relying more heavily on co-manufacturers to help create product while the company increases its own manufacturing capabilities. Given the strain in the logistics systems that have been observed in the economy, coupled with the fact that lead times probably take longer when you work with co-manufacturers, it is sensible of Medifast to increase inventory so it can meet any demand fluctuations.

Margins

Management previously gave the below guidance in May 2021, which showed Medifast generating net income margins of 10.7% - 11.3% in 2021.

In the August update, management gave the below guidance, which implies net income margins of 10.5-10.9%. There was some questions from Street Analysts regarding the increase in revenues but the flattish guidance on EPS, which signaled some margin compression. When you actually run the math, the margin compression here is 20 – 40 bps, which doesn’t seem that dramatic. As the company increases its own manufacturing capacity, it should be able to increase margins. The July 2021 economic report also suggested that inflation pressures may be showing some abating. Though EPS guidance wasn’t really raised in conjunction with the increase in revenue guidance, I don’t think there is any major margin pressure just yet.

Market Saturation

This is a significant question since the decision to invest in Medifast is dependent on how much this company can grow. In Jefferies’ initiating coverage report, the analyst described Medifast as having a $20B market opportunity, which suggests that Medifast would own 10% of the market if it reaches $2B of revenues and potentially encounter scaling challenges. Medifast estimates that its addressable market is 95M people, which is not very helpful since that implies ~30% of the US is a prospect.

As of 2Q21, Medifast has 59k coaches earning $26k per year. Medifast meal plans costing $600 per month and the average member likely does a 4 month program, so it is possible Medifast currently has ~650k active members.

The US is pretty fat and 42% of the population is obese, equating to over 130M obese people in the US. I estimate that 10-20% may be appropriate for Medifast, equating to a market of 14-28M people. Medifast thus has between 2.5-5% of the market. There is thus significant market for Medifast to grow into and more than enough market opportunity for the company to increase revenues by 2-3x. Note that once people come off a diet, weight gain often occurs thus there is a propensity for some repeat customers to emerge on the Medifast platform. Per the Company’s Jan 2021 investor presentation, the company has 76% customer repurchase rates and 47% of customers have purchased the product 4x or more.

The below map is also great to see. One concern that was voiced on the VIC was whether coaches could reach saturation in a particular area. One thing to observe is that though Medifast started with a concentration of coaches in CA and NY, the subsequent expansion of coaches has been throughout the US and there thus remains significant growth potential because this is a solution that works across the US.

Forecast

In our base case, I assume that the company is able to add another 27k coaches in 2021 (company has already added 15k coaches to date). I then assume the company can add 15k coaches in 2022 increasing to 16,500 coach adds in 2025. Revenue / coach stays in a relatively tight band but increases from $24k in 2021 to $26k in 2025. EBITDA margins start at 15% in 2021 and increase to 17% by 2025. Assuming a 15x EBITDA multiple, a 3.1x gross MOIC is achievable by 2025 representing a 29% IRR. With the 4% dividend & share repurchase yield, that increases the IRR to 33%.

The below table highlights the returns profile across different cases. Even in a downside case where coach adds decline to 10k in 2022 and revenue / coach stays flat at $24k, there is still the chance to achieve a 2.0x gross MOIC and an IRR of 20%.

Catalyst

Continued performance over coming quarter