Medifast May Be The Best House On A Scary Street

| About: Medifast, Inc. (MED)
This article is now exclusive for PRO subscribers.

In principle, weight loss should be an incredible honey pot for pharmaceutical, packaged food, and consumer service companies. In reality, it has proven considerably more difficult for anybody to make consistently good money in the space. Sometimes the problems are largely self-inflicted (Weight Watchers (NYSE:WTW) certainly comes to mind here), and sometimes the issue is more related to consumer patience/discipline.

Whatever the case, investors trying to profit from the weight loss theme through publicly-traded stocks have faced a treacherous environment. Nutrisystem (NASDAQ:NTRI) has been strong this year, but the five-year returns of stocks like Weight Watchers, Nutrisystem, Arena Pharmaceuticals (NASDAQ:ARNA), and Vivus (NASDAQ:VVUS) haven't been that great relative to the S&P 500.

That brings me to Medifast (NYSE:MED). Medifast has been quite strong relative to this group of weight loss-centric stocks (and the S&P 500 as well) over the past five years, though the last year hasn't been nearly so good. Although the company's weight control center strategy hasn't worked out so well, the relationship-driven "Take Shape For Life" has, and the company has generated some solid free cash flow of late. Although I have my concerns with the business model and the concept, the valuation doesn't seem demanding to me and this may be the best house on a very scary street.

A (Somewhat) Different Approach To A Large Market

While I would argue that weight loss has as much to do with committing to a coherent plan as the specifics of the plan (when it's all said and done, it becomes a math problem), Weight Watchers, Nutrisystem, Nestle's (OTCPK:NSRGY) Jenny Craig, Medifast, and other contenders have battled for years to develop plans, programs, and supplements to attract those who want to lose weight.

The core of Medifast's business is something of a hybrid of multiple approaches. Take Shape For Life produces about 60% of the company's revenue and is a business driven by independent "coaches" who work with those who wish to lose weight, collecting commissions and bonuses on the sales of meal replacement products, snack bars, and so on to clients and other coaches they recruit into the system. If that sounds similar to what Herbalife (NYSE:HLF) or USANA (NYSE:USNA) do, that's because I think it is - though with a more organized plan/system akin to Nutrisystem or Weight Watchers.

There has been more than a little controversy about Medifast and Take Shape For Life (and I'll get to that shortly), but it's not all of what the company does. About one-quarter of the company's sales come from its direct sales operations, where customers can order through a website or call center.

Medifast has also opened more than 120 Medifast Weight Control Centers, which offer not only a bricks-and-mortar sales channel for Medifast food products, but also customer counseling and various other services like body composition analysis. These centers haven't really worked out so well; only about half of the company-owned stores are profitable and same-store sales have plunged by double digits over the past two quarters. With that, the company is intending to transition to a fully franchised model.

Certainly Not A Spotless Story

While Medifast hasn't attracted the same level of attention and controversy as Herbalife has in recent times, that's not to say that everything here is perfectly fine.

A couple of years ago, Medifast responded to vocal critics of its business model, financial disclosures, and marketing practices by suing several of them. While a U.S. District Court has granted some SLAPP motions filed by defendants (essentially dismissing the suit against them), it has denied others and parts of this case are still ongoing.

Still, it's worth noting that the company announced a settlement with the SEC back in September of this year for various issues with its financial reporting. A subsidiary of Medifast also reached a consent decree (and paid out a settlement) with the U.S. Department of Justice and Federal Trade Commission for false advertising claims. So it is not as though everything here has been completely beyond reproach.

While Medifast appears to bristle at claims that its Take Shape For Life program is a multi-level marketing system, the fact is (according to its own 10-K) that the company does pay its "coaches" bonuses based in part on the performance of other coaches they recruit.

I also do think the company pushes it with some of its marketing approaches. This web page claims that the Medifast 5 & 1 Plan is substantially cheaper than a "daily non-Medifast diet," but the examples used (eating out for breakfast, a mid-morning snack, and lunch, and eating premium ice cream for dessert) seem a bit extreme. At a minimum I know *my* daily food intake doesn't cost anywhere near the $30 a day Medifast suggests.

All of that said, there is clinical evidence that the Medifast approach can work, including at least a couple of papers I was able to find on PubMed. So while Medifast may not be the most cost-effective weight loss program out there, and there may be legitimate objections to the business model, it is not without the potential for meaningful weight loss results.

A Model Still In Transition

I do like the fact that Medifast wants to get out of the weight loss center business and transition that to a franchise model with lower capital costs. I do have my doubts about how successful the company will be in attracting franchisees, though, as same-store sales declines of 20% and 16% in recent quarters won't help. I'm also concerned about the apparent relationship between advertising/marketing spending and sales, as the past few quarters would suggest a relatively tight relationship (spending goes down, sales weaken) that could compromise operating leverage.

On the other hand, the company already manufactures just under half of its products, and bringing snack bar production (snack bars are about one-third of product revenue) in-house could offer some incremental upside.

People aren't going to give up on the hope that somebody/something out there can help them lose weight, and it doesn't take heroic assumptions to drive an attractive DCF-based fair value for Medifast. Revenue growth of just 5% to 6% (well below the trailing 10-year rate of 34%) and free cash flow growth of 6% to 7% (based on FCF margins improving about 100bp to 150bp) lead to a fair value of $32 even with a steep 12% discount rate. That tells me that Wall Street really does not buy this story and/or assigns a steep discount rate to account for the risks inherent to the model and industry.

The Bottom Line

Truth be told, I don't like any company in the weight loss space. I have never liked how Weight Watchers runs its business, and I have my doubts about whether Nutrisystem can ever find a sustainable plan/model that drives consistent results. Even Nestle is looking to tap out, as it has reportedly decided to look for a buyer for the Jenny Craig business (after spending $600 million to buy it seven years ago). If I wanted to invest in healthy living, I might spend my time on a company like Natural Grocers (NYSE:NGVC), which I wrote about back in June.

Turning back to Medifast, I do believe the expectations are relatively undemanding for this company, and I do think they're in a growth industry. Those investors who can get comfortable with the business model may find some real value here, but even a 25% discount to what seem to be conservative assumptions isn't enough to get me to invest my own money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.