Following our previous article which outlined our macro view on U.S. equities, in particular value/dividend stocks, we thought we would share a specific trade to express it. While we do appreciate that MED fits the criteria with a dividend yield of ~5% and p/e of 15, it represents a great opportunity as a unique, high probability set-up for us. With a stock price depressed by unwarranted short-seller publicity, MED maintains impressive earnings growth, a blemish-free balance sheet, and strong dedication to returning shareholders’ capital.
Medifast, Inc. (MED) is a health and wellness company which supplies nutritional products through its network of independent “wellness coaches.” With a large general trend both in the U.S. and globally towards weight loss, the company’s growth has been rapid. Accordingly, it was formerly a high-flying growth stock. That is before the shorts took control following a variety of concerns. Related to costs, shorts pointed to the expense of finally making the necessary upgrades to Medifast’s supply chain and the costly implementation of an ERM. On a another front, notably, a headline short thesis released by Gotham City Research LLC., claimed that the company is exposed to enormous liabilities as a result of toxic substances within their health products. Finally, stigma surrounding companies engaging in Multi-level Marketing (MLM) has only drawn more shorts. They claim that there is something inherently “sketchy” about MED’s business model due to its reliance on MLM.
Moving forward, from the perspective of ignoring outside noise we believe MED continues to face the tailwinds which have driven its impressive growth up to this point. The company is surpassing its own expectations of additions of new wellness coaches, which is its primary driver of top and bottom line growth. Looking beyond more mature markets, MED is just beginning its Asian expansion. It should provide tremendous opportunity due to those nations’ more recent development and subsequent growing obesity problems. Quantifying growth, in the most recent quarter revenue grew 36.5% over the previous year’s period. While it is true that margins changed unfavorably during the period due to outside fraudulent credit card activity, the problem has been addressed and bottom line growth remains intact. Finally, the company is investing in upgrading their supply chain to better handle current and future growth. This will mean higher short-term expense, viewed negatively by the market; however, the move is absolutely necessary and a relief as short sellers have generally criticized the company for its past under investment.
While prizing our own, independent thought process surrounding trade ideas, we strongly believe in examining the perspective which defines the flip side of the trade. Addressing the validity of short sellers’ claims, we find many of their concerns fall on a spectrum from misguided to simply deceptive. Yes, in the short-term, costs will increase due to the ERM, supply chain, and technology upgrades. While long-term these will be positive, current risk would be higher, although generally wide margins leave room for absorbing these costs. However, the stock dropped ~30%, following the release of that information, more than fully discounting it as a near-term threat to the company. The other main driver of MED’s collapse was the the headline short report from Gotham Research LLC. Dissecting it, we found many of their claims to be highly doubtful and in specific instances, plain false. The “side effects” of Medifast’s products, which Gotham links to lead poisoning, just so happen to be the human body’s reaction to an abrupt transition to a keto diet(definition of Medifast’s program). This claim regarding lead contaminants in Medifast products underpins Gotham’s whole argument, and they model potential liabilities to the company based off of a previously open legal case alleging health problems due to product contaminants. No settlements or further action transpired as there was not enough of a substantial case. This completely undermines the credibility of Gotham’s argument. It is probably for this reason, combined with a vastly over-sold stock that Gotham just removed its short recommendation.
Finally, having outlined our thesis, we will explain how to view actually trading it. Please be aware that we do currently have an open position and may choose to add, decrease, or close it at any point without warning for a variety of reasons. This is especially important to specify in this case as Medifast is not a “buy and hold forever” stock. They spend close to nothing on research and development, and their product does not provide a long-term approach to weight loss, or even a particularly healthy one. Without customers continuing to buy the product for life, they cannot maintain their body change, because they are not making a true lifestyle change. Eventually, we believe better, more holistic, innovative solutions to weight loss will crowd-out programs like Medifast. However, in the short and medium term, Medifast has significant momentum in its business, largely due to its expanding network of wellness coaches and the fact that customers have to keep purchasing the product to maintain their weight loss. As of most recent figures, short interest in the stock remains near its highs. Therefore, we see a short-squeeze as being highly probable. We believe the stubborn shorts fail to properly distinguish between the fundamentals of very long-term and the short and medium terms. As value comes back into favor, and a new activist investor effects some necessary changes, it would not be inconceivable for the stock to double from here. Buy the dips, but constantly monitor the story, particularly with regards to the momentum of the wellness coach network growth and upgrades to the supply chain.