Stunning Growth but Questionable Management

April 9, 2012 | Comments (9)

Obesity in USA has increased dramatically. USA is the most obese country in the world by a large margin and there is a long way to go before this fact changes.

30.6% of the USA population is obese, with Mexico coming a distant second at 24.2%. If you include Americans falling into the overweight category, 70% of the population fall into this category.


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Jae Jun

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[edit] Certain parts of this article has been reworded/rephrased as it seems like MED is more focused on threatening bloggers with civil suits to retract opinion articles as opposed to focusing on improving their own business or business model.

This article was written based on the 2010 10-K which you can find in the SEC.

What lawyers don’t understand is that an investment requires an analysis of the past and present. This article was written based on the 2010 annual report and proxy because I felt that it provided good pieces of information.

Obesity in USA has increased dramatically. USA is the most obese country in the world by a large margin and there is a long way to go before this fact changes.

30.6% of the USA population is obese, with Mexico coming a distant second at 24.2%. If you include Americans falling into the overweight category, 70% of the population fall into this category.

Obesity is not age specific and this is not surprising because children now sit at home, eat and play games. Many adults work a desk job and then relax at home with family without much exercise.

Life gets busier it seems with each year, and to compensate, people eat fast food to stay on schedule.

This sets the scene for the business. The weight loss industry is worth approximately $55bn. This includes diet foods, drinks, low calorie sweeteners, health clubs, workout videos, weight loss programs, children’s weight loss camps, diet books , appetite suppressants and more.

As you can see, there is a lot of competition and a huge variety of weight loss/management.

Medifast (MED) Business Description

This brings me to Medifast (MED). Medifast is #12 in the 2011 Forbes 100 Best small companies list (was #1 in 2010).

The company makes, sells and offers products for weight management, meal replacement and vitamins. All this is done through the following subsidiaries:

  • Medifast direct – direct to consumer through website (www.choosemedifast.com)
  • Take Shape for Life – Personal coaching – direct selling
  • Medifast Weight Control Centers – brick and mortar clinic channel. Also offers franchise opportunities.
  • Medifast Wholesale Physicians – physicians carry Medifast products and resell to patients

Medifast Spider Graph

  • Management: ???
  • Growth: A
  • Moat: C
  • Risk: C
  • Valuation: B
  • Overall: You decide. I’m not touching this.

Where did/will Growth come from?

Revenue growth has been huge but the main driver has been from Take Shape for Life, which is the single level direct selling MLM (Multi Level Marketing aka pyramid scheme) arm of the business.

Take Shape for Life is a direct selling company and not an MLM so I’ll retract my comments on MLM. Direct selling is where a salesperson is paid only for the sales he makes himself. MLM is where the salesperson is paid for selling and for sales made by people he recruits or sponsors.

The annual reports do not specifically state that they use a pyramid MLM operation but doing a little search shows that the business model is indeed based on MLM.

This concerns me on multiple fronts. MLM is all about making money. The product could be good, but because of the “opportunity” presented to make money, a lot of new members are in it for the money vs the actual benefits of the product. Somewhat confirming my sneaking suspicion is that the rest of the business is losing money.

However, the rest of the business is losing money.

MED clearly wanted me to mention this statement from the annual report about them losing money. This is from the 2011 10-K.

MWCC and Wholesale Segment: This segment decreased net profitability in 2011 as compared to 2010 by $9.5 million. The decrease in net profitability is primarily due to the hiring of expertise in key areas to build the internal infrastructure to open new Medifast Weight Control Centers in 2011 and beyond. Hires included regional trainers, district managers, area managers, mobile managers, Dietitians, HR recruiters, operations support, and marketing. In addition, thirty-one new corporate centers were opened in 2011. Start up costs such as rent, other office expenses and new employee hires contributed to the decreased profitability of the Centers.

My response is, so what?

Losing money is losing money. I wrote that the business is losing money based on the 2010 annual report, but it is the same in 2011. Actually it is worse. The numbers state that “all other businesses” is losing money.

In 2011, all other segments was down 21% compared to being down 18% in 2010. Just because you hire like crazy, does that mean it is OK to lose money?

  • The real question is, is the increasing revenue due to an awesome product? Or is it due to the MLM make money aspect?

Strategic Advantage or Moat

Medifast says that they compete through their science and research on weight loss, but if you give the same budget to another company, I’m sure they could do the same. Science and research is not an advantage.

I see no real advantage MED has over its competitors.

Lots of Competitors

Competition is huge in this business. Everything from supplement makers, gyms, workout instructional guides/videos, personal trainers, diet cook books etc.

Anything sold related to weight loss or weight management is competition.

Current direct competitors include:

  • Nutrisystem (NTRI)
  • eDiets.com (DIET)
  • Herbalife (HLF)
  • USANA Health Sciences (USNA)
  • Weight Watchers International (WTW)

Severe Risks

  • If a new weight loss trend appears, Medifast will be affected.
  • Government regulation risk
  • Not one single mention of MLM yet many blogs show that Take Shape for Life clearly is MLM. I don’t know whether that is the norm. I could look up Herbalife and compare since they are MLM too.
  • Huge cookie jar increase. In Dec 31, 2010 the provision for returns was $207k compared to $70k in 2009. Not a good sign.

Valuation

  • Strong earnings, fantastic margins and returns, very strong balance sheet, big FCF growth
  • Huge cookie jar increase
  • Days Payable Outstanding more than doubled from 2009
  • Rough calculations show the company to be worth $23-$30.

Things to think about Regarding Management

Current chairman of the board was the previous CEO until 2007. He was also responsible for turning the company around. The chairman also co founded Take Shape for Life and received an “Entrepreneur of the year” award. I like founding CEO’s much better than corporate CEO’s.

    The previous Current CEO was only 33 years old and left the company in Feb 2012. He became CEO in 2007 which means he was 28 years old. He originally joined the company in 2002 at the age of 23. Before that he was a senior analyst for the Blackstone Group.

    I wonder how old you have to be before becoming a senior analyst at Blackstone.

    What I find troubling is why and how did he become CEO with such a short history with the company?

    I want to know what the board of directors were thinking, how this decision was made. Having 4 executives on the board can make it lenient and more attractive for executives.

    What’s more, his team consisted of a CFO 33 years of age and COO who is 33 years of age. Again, according to the 2010 docs, I find it very troubling about this direction from the company.

    This was one of the youngest management team I have ever encountered.

    There are lots of young entrepreneurs in their 20′s and 30′s but the CEO in 2010 did not create the company, and I just don’t see how a person without any prior relationship with the company and only background as a senior analyst rise to CEO in 5 years at 28 years of age. Impressive but questionable.

    Moving on…

    Compensation in 2010 is as follows, expect more in 2011;

    • Chairman made $1.31m
    • CEO made $1.66m
    • CFO made $1.45m
    • Total Revenue is $257m

    Compared to total revenue, compensation is “ok” but the sum is still huge.

    Herbalife (HLF) has taken a big hit by famous value investor, David Einhorn, questioning their disclosures. It also turns out that the HLF is one of the highest paid CEO’s. It seems like huge compensation packages are considered acceptable in direct selling business model business.

    Concerns

    If you only read the latest 2011 10-K report, you would have missed this, but right from the beginning of the 2010 annual report, you are give an explanatory note about accounting issues regarding how the company recorded expenses.

    “Certain costs and expenses affecting SG&A expenses and cost of sales, to include shipping expenses and certain web advertising expenses, which due to growth and evolution in the business model were consistently expensed in the following month after services were rendered, rather than being accrued in the proper period.”

    This means that expenses were recorded when they were paid instead of when it was incurred. The accounting was deemed material and requires restatement for the years 2008 and 2009. (Actually the report shows reinstated numbers back to 2006.)

    Net income in 2009 and 2008 was reduced by $606k ($0.04 eps diluted) and $523k ($0.04 eps diluted).

    Nothing illegal, but if it was immaterial enough to reinstate for several years, other accounting policies must be questioned. Look at what happened to Diamond Foods. Their accounting methods were not illegal, but it was shady enough to warrant an investigation and ultimately a restatement wiping out millions of dollars in the company value.

    Fraud Claims

    (It seems like MED and their lawyers don’t like anyone linking to the below sites. In any case, it is best to check out what these people have to say. Do your due diligence in looking at each one.)

    I came upon some links claiming that MED is a fraudulent business to which MED filed a civil complaint on Feb 17, 2010.

    Tracy Coenen is a forensic accountant and fraud examiner in Chicago and Milwaukee who investigates white collar crimes, including cases of financial statement fraud, embezzlement, tax fraud, and insurance fraud. She has been raising questions about Medifast since 2009.

    It also concerns me when other noted criminals come out and question Medifast’s business practices.

    In the book The Art of Short Selling, there is a case study on Crazy Eddie and coincidentally, I found the blog of former Crazy Eddie criminal CFO who also discusses Medifast.

    I’m a firm believer that it takes a criminal to know a criminal.

    Here is what it says in the 2011 10-K about the civil suit MED initiated.

    The Company filed a civil complaint on February 17, 2010 in the U.S. District Court (SD, Cal) against Barry Minkow, his Fraud Discovery Institute, Inc., its subsidiary iBusiness Reporting, its editor William Lobdell, as well as Tracy Coenen, her Sequence, Inc., “Zee Yourself”, and Robert L. Fitzpatrick for defamation and violations of California Corporation Code Sections 25400 et seq and 17200 et seq, alleging a scheme of market manipulation of  Medifast stock for Defendants’ monetary gain, by damaging the business reputation of Medifast and its meal replacement weight loss products. Bradley T. MacDonald, Executive Chairman of Medifast, who is also a large shareholder of the Company, joined the lawsuit individually. The suit seeks at least $270 million in compensatory damages, punitive damages, and ancillary relief. The Company continues prosecution of this civil suit. The Company also continues to pursue its pending complaints filed in March, 2009 with the SEC, Maryland Securities Commissioner, and the U.S. Attorney against most of these same named defendants with respect to the related matter.

    Looks like it is still ongoing. No conclusion is stated in the document yet.

    But you get the idea. They want to try and do the same thing for this article.

    Conclusion

    From a numbers standpoint, the company is seeing excellent growth, but the earnings quality is horrible especially in light of the huge cookie jar increase. Personally, one too many questions were raised in my mind that I am not comfortable with.

    I have no opinion of whether Medifast is legit or not, but this is an easy pass as an investment for me. I’d rather be safe than sorry. Lots of other fish in the sea.

    If they are this picky over an investment article, I don’t want to touch or even trust the company. Why would I want to own a company that spends its money on hiring lawyers to retract articles from seeking alpha?

    External Links and Other Opinions

    http://philtown.typepad.com/phil_towns_blog/2011/07/medifast-is-a-value-trap-for-rule-one-investors.html

    http://industry.bnet.com/healthcare/10001126/medifast-part-two-weight-loss-miracle-or-pyramid-scheme/

    http://seekingalpha.com/symbol/med?source=search_general&s=med

    http://www.gurufocus.com/articles.php?symbol=MED

    Disclosure

    No position.

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