Whenever an investor finds a stock that looks simply too cheap, it's wise to question why that may happen. Some stocks are simply under-followed and over-looked and represent real bargains. In other cases, investors have made mountains of molehills and overestimate the risks present (or underestimate the growth). Then there are cases where the Street may be right to be wary and cautious, and a seemingly cheap stock is, in fact, priced appropriately for the risks.
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In that vein, it's worth taking a closer look at Medifast (NYSE:MED), as this growing weight loss play seems cheap, relative to historical financials.
What Medifast Does
Medifast is an odd hybrid of the weight loss models promoted by Weight Watchers (NYSE:WTW), Nutrisystem (Nasdaq:NTRI) and Herbalife (NYSE:HLF). Like Herbalife, the company sells supplements (as opposed to FDA-approved pharmaceuticals) and sells some of its product through a direct sales model. (For related reading, see Weight Watchers- Yo-Yo Performance And Debt Gluttony.)
Like Nutrisystem, Medifast offers portion-controlled meal replacements that allow dieters to limit their caloric intake while getting necessarily nutrients. Like Weight Watchers, Medifast has a growing store-based approach that not only sells Medifast product, but offers a certain degree of coaching and emotional support.
The comparisons are not identical or perfect by any means (Medifast does not offer the meetings-based format like Weight Watchers), but Medifast seems to be trying to cherry-pick some of the better ideas that have shown some past success in the weight loss industry.
A Company Still in Transition
Medifast recently changed its leadership, electing not to renew or continue former CEO McDevitt's employment contract. Instead, the company named Michael McDonald to the CEO position, increasing the influence and control of the McDonald family over this company.
This is not the only transformation at the company. Medifast continues to expand its store footprint, looking to add perhaps 35 new centers in 2012 (versus 39 at the end of 2010). Medifast also continues to look to expand its network of partners; about 20% of the company's Take Shape for Life coaches are healthcare professionals, and Medifast has had some success in penetrating the physician community, which means that doctors refer/recommend the products to patients looking to lose weight.
Ample Challenges Remain
Medifast is certainly not as old as Weight Watchers or Nutrisystem, but the company has yet to make a significant impact on the popular consciousness. For better or worse, almost anybody considering weight loss is well aware of the services that Weight Watchers and Nutrisystem offer, and probably knows somebody who has had a measure of success using them.
So, while Medifast does have some clinical data to support its approach, the company does compete with well-established rivals.
Medifast also may have emerging competition to worry about relatively soon. While approval is far from certain, Vivus (Nasdaq:VVUS) may get FDA approval to sell its weight loss drug Qnexa in the next month or so.
Though there are side-effects and Qnexa doesn't allow a person to eat however they please and still lose weight, there is a lot of convenience inherent in a weight loss pill. What's more, Qnexa is potentially a more cost-effective option; likely costing $4 to $5 a day (versus the $10-$12 a day with Medifast meal replacements) and could be covered by insurance.
Moreover, it's not just about Qnexa. Arena Pharmaceuticals (Nasdaq:ARNA) and Orexigen (Nasdaq:OREX) are still trying to get approval for their weight loss drugs, and though investors may overestimate the potential of weight loss drugs in the market, the reality is that an effective drug is a threat to other weight loss options.
The Bottom Line
Medifast runs a business model that can theoretically be exceptionally profitable with scale. The company produces more than half of its product and its weight loss centers tend to be profitable within a year of construction.
The problem is that revenue momentum has slowed of late and investors have been quick to extrapolate this slowdown. If the company can maintain double-digit revenue growth and steadily improve its free cash flow conversion, the stock is definitely undervalued. Management has to reestablish its growth credibility, though, and investors may well choose to stay away until they know more about the potential impact of Qnexa on Medifast's market. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.