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.

Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

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.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Investing News

    What You Can Learn from Carl Icahn's Mistakes

    Carl Icahn has been a stellar performer in the investment world for decades, but following his lead these days could be dangerous.
  2. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  3. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  4. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  5. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  6. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  7. Stock Analysis

    The Top 5 Micro Cap Biotechnology Stocks for 2016 (BSTC, OSIR)

    Discover some of the most promising micro-cap biotechnology stocks that investors can consider for their 2016 investment portfolio.
  8. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  9. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  10. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center