Medifast, Inc.
Q3 2019 Earnings Call Transcript

Published: 8 Nov 2019

[Operator:]

Good afternoon, and welcome to the Medifast Third Quarter Fiscal 2019 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, today’s event is being recorded.I would now like to turn the conference over to Katie Turner. Please, go ahead ma’am.

[Katie Turner:]

Good afternoon, and welcome to Medifast’s third quarter 2019 earnings conference call. On the call with me today are Dan Chard, Chief Executive Officer and Tim Robinson, Chief Financial Officer.By now, everyone should have access to the earnings release for the period ended September 30, 2019, that went out this afternoon at approximately 4

[Dan Chard:]

Thank you, Katie, and good afternoon to everyone joining us. Thank you as always for your interest in Medifast. I’ll start today’s call by giving you an overview of our third quarter performance, then Tim will review the financial results in more detail and provide our fourth quarter and full-year guidance. We’ll then both, be available to take any questions.Medifast continues to be resolutely focused on driving long-term sustainable growth for all our stakeholders, as we dedicate ourselves to our central mission to offer the world lifelong transformation, one healthy habit at a time. We firmly believe that Medifast revenues can double every three to four years and that this growth path can be maintained for considerable time to come. With our eyes are very much on that consistent growth trajectory, we are investing in the development of our organizational capability, our skills, and our geographic footprint. We believe this strategic focus will allow us to take advantage of the significant opportunities that lie ahead.Our coaching model is at the heart of Medifast competitive difference with clinical studies demonstrating that people, who have a coach alongside them on their weight loss or health transformation journeys, achieve and maintain better results than those, who go it alone. With that in mind, we’re placing a clear focus on building and developing our coaching community, giving them all the vital tools necessary to help us increase the number of people we reach every day with our products and services.We’ve celebrated our growth in active earning coaches during the quarter, and have exceeded even our own challenging goals. Having set ourselves a target of securing 30,000 coaches by the end of 2019, we significantly outpaced our schedule and surpassed 30,000 coaches in the second quarter of the year. We’re now wealth on course to reach our stated goal of 50,000 active earning coaches by 2021, a milestone, which we believe will play a lead role in our abilities to deliver $1 billion in revenue with an operating margin greater than 15% about the same point in time.We’re not just adding new coaches. We’re also maintaining a high level of productivity. Average revenue per coach was relatively stable in the period despite the continued increase in coach numbers demonstrating the success we’re having in helping the coach community optimize their individual businesses. Coaches are central to our success. As such, it’s vital that we continue to develop our approach to development, networking, and fill the alignment to be certain we’re providing coach leadership in the wider community with an easily repeated, scalable process and workflow to drive growth.Providing opportunities to bring leaders together to impart best practices, share intelligence from the field and develop new skills is very important to our mission. Last month, we hosted our latest international leadership alignment summit in Sundance, Utah. This event brings together more than 150 of our key OPTAVIA coach leaders, along with senior executives from Medifast to share information, train the next generation of coach leaders, and ensure that we listened to and incorporate the feedback of our coach and client community.Most importantly, we worked collaboratively to align behind the shared vision for the future. Focusing on our goals for the next two years, reviewing and enhancing our product and technology roadmap and optimizing coach and client support to support our long-term growth projections. The event was also notable for the broadened focus on our international business with many of our leaders now managing coaches in our first two expansion markets

[Tim Robinson:]

Thank you, Dan and good afternoon everyone. I’ll review our financial results for the third quarter ended September 30, 2019, then I’ll provide our fourth quarter guidance and discuss our 2019 outlook.revenue in the third quarter of 2019 increased 36.5% to a record $190.1 million from $139.2 million in the prior-year period. We ended the quarter with a record 32,200 active earning coaches compared to 22,600 in the same period last year and 30,600 in the second quarter of this year.Average revenue per active earning coach for the quarter decreased slightly to $5,715 compared to $5,781 for the third quarter last year. We believe this slight decline was a result of operational headwinds that will continue to put downward pressure on this metric in the fourth quarter. We do expect average revenue per active earning coach to return to normal levels in 2020.OPTAVIA-branded products represented 78% of our total company consumable units in the third quarter compared to 70% in the prior-year period.Gross profit for the third quarter of 2019 increased 33.3% to $142.9 million compared to $107.2 million in the prior-year period. Gross profit margin, as a percentage of net revenues, decreased 180 basis points, 75.2% versus 77% in the third quarter of 2018. the decrease in gross profit margin percentage was driven largely by higher shipping expenses and higher product returns related to disruptions that Dan mentioned earlier.SG&A for the third quarter of 2019 increased $33 million to $122.7 million compared to $89.7 million for the third quarter of 2018. The increase is primarily a result of higher variable costs such as OPTAVIA commission expense and credit card processing fees along with higher costs for a highly successful annual convention, held in July and increased consulting costs related to information technology projects.Lastly, as Dan mentioned, we had a significant increase in costs in the quarter related to used stolen identities and credit cards from outside our systems, to transact business on the our e-commerce sites. We estimated total impact on SG&A in the quarter related to these transactions, was approximately $3.2 million, which is approximately $2.9 million higher than the prior-year period.These expenses were primarily comprised of higher bad debt expense and credit card transaction fees. We successfully addressed this situation and brought bad debt levels down to levels that are consistent with historic performance. We do not anticipate any material ongoing expenses related to this matter going forward.SG&A as a percentage of sales increased 10 basis points to 64.5% of total revenue compared to 64.4% in the third quarter of 2018. our effective tax rate was 22.7% in both the third quarter of 2019 and 2018. the effective tax rate was negatively impacted by the tax effects of foreign operating results, offset by favorable effects of state income taxes.Net income in the third quarter of 2019 was $15.9 million grew $1.32 per diluted share, based on approximately 12.1 million shares outstanding. Third quarter of 2018 net incomes was $13.8 million or $1.14 per diluted share based on approximately 12.1 million shares outstanding.Our balance sheet remains very strong with stockholder’s equity of $111.2 million and working capital of $80.8 million as of September 30, 2019.Cash, cash equivalent and investment securities as of September 30, 2019 decreased $4.1 million to $96.9 million compared to $101 million at December 31, 2018.The company remains free of interest-bearing debt. inventory increased $13 million to $51.9 million as of September 30, 2019, fair to $38.9 million at December 31, 2018 due to advanced preparations for new international products, initial production of the new Habits of Health system and the continued effort to maintain inventory levels to meet current and future demand.Our board of directors declared a quarterly cash dividend in the third quarter of $8.8 million or $0.75 per share payable on November 7. The company be also repurchased approximately 225,000 shares during the third quarter. following this repurchase, our board of directors authorized an additional two million shares for repurchase. There are now approximately 2,369,000 shares of common stock remaining under our share repurchase program. our management team and board of directors remain committed to enhancing value for our stockholders.Now, turning to our guidance. We expect the fourth quarter revenues to be in the range of $157 to $167 million and EPS to be in the range of $1.03 to $1.13. for the full year of 2019, we are updating our guidance and now expecting revenue in the range of $700 million to $710 million and EPS to be in the range of $5.80 to $5.90.our fiscal year 2019 guidance assumes a 21% to 22% effective tax rate, exclusive of any discrete tax benefits from share-based compensation awards vesting in the fourth quarter. Our revised guidance reflects the second half impact of the short-term headwinds as Dan described earlier related to credit card related bad debt and migration around both our technology and our supply chain.The company is in solid financial position. In the fundamentals, our business remains strong. We’re confident in the future growth prospects and are focused on delivering our goals in order to create long-term shareholder value.That concludes our operational and financial overview. We appreciate your interest in Medifast. Dan and I are now available to take your questions. Operator?

[Operator:]

Thank you. [Operator Instructions] Today’s first question comes from Linda Bolton Weiser of D.A. Davidson. Please go ahead.

[Linda Bolton Weiser:]

Yes. Hi. So, sorry if I didn’t quite catch all the explanation, but I guess what I’m a little confused about is did this fraudulent activity occur in the third quarter and if so, why is it the fourth quarter results that seem much more impacted than the third quarter? That would be my first question. And secondly, I’m not sure I kind of understand. I mean, obviously, this doesn’t sound good that there’s fraudulent activity here, but how does it like, affect the coaches, because they just are misled about what their downline earnings are, but how does that actually affect the servicing of their existing clients as long as those clients are getting their orders.So maybe, you could just give a little more color about exactly what’s going on. And then my third question is clearly just these are IT problems and we’ve had a little sense in the last year or so, the certain deadlines have slipped on your IT front. So, are you making some personnel changes? Do you need to bring in special consultants to fix all this? And then just maybe, restate again your estimation of when your business will be operating normally again, will it be first quarter 2020, second quarter 2020? Because the diet season is coming up. Thanks.

[Dan Chard:]

Sure. Hi Linda, this is Dan. Yes, let me add a little bit of color to what we just described. from the credit card standpoint, we’ll give you a little bit more description. These were fraudulent credit cards and identities that were executed through computer bots, basically leveraging stolen identities and stolen credit cards. Each of the credit cards payment or charges were authorized by the bank. The order was placed, the shipment was sent and then the bank came back and reported those as stolen. So that’s the impact to the company profitability. In terms of how it impacts as the coach experience or the client experience? What, I mean, our coaches are very much tied and our business is very much tied to client acquisition. So, each of these clients, who comes in who are tied to a stolen identity, don’t repeat their purchase. So that has an impact on what coaches think they’re doing from a business standpoint. So that’s the – that’s kind of the part of the headwind in terms of the coach experience.related to the IT problems. We have essentially over the last two years changed out every one of our critical systems. And each time, we’ve done that we’ve been replacing in some cases systems that are the end of life and have migrating data that’s been our systems for a while. So, most of the challenges haven’t been tied to the technology per se, but much of it has been tied to the specific migration of the data. We have, over the past I’ll say nine months, hired significantly in the area. And also brought on the top-tier partners to kind of help us through this in all these – in all these areas. Not just help us through this, but really to establish the platform going forward.So, I guess there your last question to restate when we think we’ll return to normal. these issues with credit cards all happened in the second and third quarters. At the point when we realize by – through our – through being informed by the banks, we – it was the third quarter, and at that point, we put in place technology to stop. So, by the time, we found out, put the technology in place to stop it. We had – we effectively mitigated those issues by the end of the third quarter, so that specific credit card challenge was ended at the end of the third quarter. So, we won’t have that as a recurring challenge.The other things that we mentioned technology issues related to the changeover in our technology system. These are some very – some fairly, I’ll call them minor bugs that related to how our clients let us use our reordering platform and how they changed their orders. And we became aware of those in the third quarter as well. And at this point, we’ve had two technology releases. So in this quarter, that’ll be gone to fix those challenges and we anticipate by the end of the quarter, those will be largely complete.The last area, which you mentioned was the supply chain. I’ll give you the easiest example to understand. We added about 40% capacity to our supply chain in the third quarter, it meant dismantling our pick lines in the distribution center and install new equipment. And the interim solution involves changing our distribution processes for our supply chain employees. So, the effect of that was some order – in order inaccuracies and some impact on a packing quality. So that was completed. So, it started in may and was completed by effectively mid-September. So that the supply chain is now operating as it was before. So, we anticipate that through the fourth quarter. Many of these problems are largely addressed. by the end of the fourth quarter, mostly addressed and we expect client acquisition to reach – client retention returned to normal in the first and second – first and second quarter of the New Year.

[Linda Bolton Weiser:]

Thanks. Can I have one follow-up question? So, if there was ordering and then shipment of products that was false, are you saying that your revenue in the second and third quarters was false?

[Tim Robinson:]

Hi, Linda. this is Tim. Sorry, my voice is shot. No. So, this is a legitimate revenue, we took an order, we shipped the products. It’s bad debt expense. And some of this happened in the second quarter, some of it happened in the third quarter, but the expense all hit for the most part in the third quarter. So, the proper accounting for that is revenue and bad debt expense.

[Linda Bolton Weiser:]

So again, why is the fourth quarter – the fourth quarter that’s disappointing us on earnings and not the second and third quarters?

[Dan Chard:]

The third quarter was impacted largely by profitability. The fourth quarter is as you’re aware, Linda that the most important activity that happens in our coach model is the acquisition of clients, because the client acquisition or was impacted through the three areas that I described and retention was affected. We’re going into the fourth quarter with a lower number of clients. So, that’s why as Tim mentioned, we anticipate some downward pressure on client – or a coach productivity into the fourth quarter. Then as client retention and acquisition returns to normal as these three areas of as credit card – credit card challenge is fixed, supply chain returns to normal and the technology fixes were in place. We anticipate that client acquisition and client retention will return to normal. So, the fourth quarter drag is a result of entering the fourth quarter with a lower client – total client account than we would normally have.

[Linda Bolton Weiser:]

Okay. Thanks. I’ll pass it on.

[Operator:]

Our next question today comes from Doug Lane of Lane Research. Please go ahead.

[Doug Lane:]

Yes. Hi, good afternoon everybody. Staying on that thought, Dan, your coach number in the quarter was actually a little bit better than what I was looking for. So, I want to try to parse through all these cross currents and what you’re seeing the impact is at the top with your coaches. So far nothing, but maybe, that’s the last thing to be residually impacted. So when we’re looking at the fourth quarter, you’re halfway through it and probably through the seasonally, most important part of it. Have you seen a slowdown at the top levels of your coaches?

[Dan Chard:]

Yes, Doug. We met with our top sales leaders, coach leaders in Sundance just a month ago. And we described to them the challenges we were facing specifically related to the technology and supply chain and described to them the plan to address those issues. So, they’ve obviously been experiencing the things that we described in terms of lower client retention and lower client satisfaction. Together, we work through what it would take to have everything returned to normal. And then as I mentioned those well, we put two promotions in place, client acquisition promotions to help generate the activity we need in the fourth quarter to get things back to where they should be.So, I would say our coach community is positive. They understand why we experienced these headwinds for cross currents as you referred to them and how we’re getting back to the normal state and how they can then take the activity or the promotions that we have in place for the fourth quarter and start doing what they do well, which is acquiring clients, helping them get on plan on their health journey, and then helping a portion of those clients become coaches. So, we anticipate all of these things are very short-term oriented. We’ve identified them and they’re – there’s nothing kind of fundamental in the deeper aspects of the business, where the confidence of our coaches that’s been effective.

[Doug Lane:]

That’s important. Thanks for that color. And Dan, you’ve gone through a rapid growth phase here and I’m always concerned with hypergrowth with these kinds of models and you made it through a year ago at hypergrowth and now we’re starting to see a little bit of strain on your infrastructure, both the financial, the ERP implementation, the supply chain. Have you thought about what is the board’s position or have you thought about internally expanding your Senior Management roles? Because throughout this, you’ve added managers in the midlevel for sure, you’ve added physical capacity and now, IT capacity. But for instance, there’s no Chief Operating Officer here. How much do you think given what’s going on in the last six to nine months that maybe, it’s time to beef up the senior management roles?

[Dan Chard:]

I think as I expressed earlier, we’ve added a lot of breadth and experience to our Senior Management level. So, I’m confident in our Senior Management team. Again, I think, if we saw some real missteps, meaning that things that were systemic and that will drive deeper into the overall supply chain strategy, IT strategy, I think would be more concerned about that. But the issues that I’ve described and I mean don’t get me wrong, it’s been a very difficult quarter as we’ve worked through them and focused on addressing the issues completely. But the issues I’ve described are largely started and will end in the course of two quarters. And so we’ve – what would put in place from – everything from our technology platform to our supply chain platform is in place and the foundation is solid and ready to deliver on our long-term set of goals, which are to grow our active earning coaches to 50,000, which will allow us to achieve our $1 billion goal and we believe we can do that as we leverage our infrastructure and grow our operating margin to a 15% or better.

[Doug Lane:]

Okay. Just lastly, Tim, when you started talking about the ERP system probably on the first quarter conference call, and I think you had a number of $5 million to $8 million, to implement it, which is viewed pretty much as a one-time kind of expense. Can you update us on that number and then indicate maybe, the time period? It sounds like it won’t just be 2019 that there’ll be some residual spending on ERP in the first half of 2020. Any added information there?

[Tim Robinson:]

Yes. I’ll do my best here. Sorry. Yes. All right. So, we’ve been able to pull back on some of our spend this year by approximately about $0.5 million, because we delayed the implementation. It’ll be a little bit tricky next year, we’ll incur some additional expenses, but the accounting rules around cloud software are changing and we believe that starting next year, we’ll be able to capitalize some of the costs that we’ve been expensing historically. So, we haven’t completed our outlook for next year, but I don’t think there’ll be a material impact on 2020 related to the delay. The total cost impact is about $800,000 by shifting, but a good portion $800,000 will get capitalized.

[Doug Lane:]

Got it. Okay. Thank you.

[Operator:]

[Operator Instructions] Today’s next question comes from Stephanie Wissink of Jefferies. Please go ahead.

[Dan Chard:]

Hi, Stephanie.

[Stephanie Wissink:]

Thanks. Good afternoon, everyone. I’m wondering if we can just stay on this credit card situation a bit more, can you talk a little bit about the customer fall off or maybe, all three of the issues wrap together. You’ve mentioned customer retention a number of times. you look the number of customers or clients and if you can give us a sense of what that falloff might be. And then as you’ve described this, you really talked about it as a bit of an air pocket, so that the trend line kind of continue into 2020 based on the fundamental growth you’ve seen. Is that the best way to think about it that this is really a Q3, Q4 pocket of one-time events and we should start to see the business flowing consistently into 2020?

[Tim Robinson:]

Yes, Stephanie. Dan mentioned the credit card transactions affect both the company and the coach as far as their outlook on the future. So typically, we have a customer comes in, they repeat multiple times for many months. And so even when we were doing our outlook, for example, for the third and fourth quarters, we didn’t know what at the time, but there were thousands of transactions that in our systems that were never going to repeat. And so we did our forecast or our guidance for the full year, we actually raised our guidance based on what we were seeing. The same thing happens to coaches. They expect a certain amount of repeatability to a new client as well as trying to reach out to one of these credit card clients and the frustration that we’re hearing back from them is also an inefficient use of their time.So, it kind of just affects the coach and the company to some degree in the same way that you have this kind of false business in your outlook that never comes to fruition. you can imagine for a coach, probably FX or motivation as well when they think they reached a threshold only to find out that the business never comes through in the following month. So, it’s very frustrating for a coach as well. So that’s how the credit card transactions kind of affected our Q4. It’s more in that the activity is not there that we thought was going to be there. And so customer retention is affected by two separate things. What one is this credit card information that you also see a dramatic falloff of customers that you didn’t expect, and then the other is just from client experience, we’re seeing a propensity of customers that were acquired in the past quarter or so, not stay as long because we believe they haven’t had a positive experience. So, once we returned that experience back to normal, there’s no reason why we believe that client behaviors, I’ll say over to normal.

[Stephanie Wissink:]

Okay. And then if we think about the total cost, I think, you mentioned a little over $3.5 million, but that’s just for the credit card event, right? Not the total drag from the three technology related events?

[Tim Robinson:]

Yes. It’s credit card and I’ll say credit card related. So, it includes the bad debt, it includes other costs related to the bad debt, so for example, we brought a professional firm in to help us stop it. We had an additional credit card transaction fees, every time we had an attempt, we pay a fee to check the ability to that card. So, the $3.2 million is the total cost related to the bad debt transactions, it has nothing to do with the other two items.

[Stephanie Wissink:]

Okay. And then finally, can you just talk about the remediation effort? It sounds like you put in a technology layer that’s helpful to validate the authenticity of the cards. Can we just talk a little bit more about that? Just so we understand that what you’re seeing in your business today isn’t still being impacted by some of this fraudulent activity?

[Dan Chard:]

Yes. The technology layer is a security software that essentially used an outside database to first look at credit cards. And then it also looks transaction types. We’re able to program in the logic. So, we had a very quickly, climb the learning curve and understanding exactly what was happening and programmable logic in to address those specific types of transactions. And very quickly, we’re able to get the bad debt expense back down to a normal level. But it happened very, very quickly. As I mentioned before, it was used computer bots stolen identities. And so during the initial phase, it wasn’t apparent what was happening, because the credit cards were being authorized by the banks. So, they came across our systems as looking like they were legitimate individuals with legitimate credit cards. And by the time, the bank told us that they were reported to stolen the shipment had already gone out.So, the software addresses that activity on an automated way and we continue to monitor obviously, this on a daily basis, but we have effectively returned it all the way back down to where it’s the level of bad debt has been historically. So, it’s – the issue is – that specific issue is behind it and we’re confident in the vendors we’re using to help us ensure the security of our systems going forward.

[Stephanie Wissink:]

The final one for us is just on your fourth quarter guidance. Does it contemplate any improvement from the current trend of business? So, if the supply chain and the technology migration were to be less of a factor, would that provide upside opportunity or have you built in some improvement into the fourth quarter as the quarter progresses?

[Tim Robinson:]

Yes, I think, Stephanie, we tried to be conservative. We tried – go ahead, Dan.

[Dan Chard:]

Yes. We tried to be conservative in the guidance. Like I said, we believe that we have a good handle on the issues and the resolution, and we’ve basically re-prioritized all of the projects to allow us to quickly and effectively, mitigate any of the headwinds that were being created by these last two issues on – from the supply chain side, which I mean, that one is complete. And then the last one is the technology side. So, we believe that that there’s no reason that our client retention and client acquisition won’t return to the normal level, particularly, as I mentioned, because we’ve put in place some incentives to help our coaches during – through the challenging size – the challenge side of the business that that’s been created by the headwinds.

[Stephanie Wissink:]

Thank you.

[Operator:]

And ladies and gentlemen, this concludes the question-and-answer session. I’d like to turn the conference back over to the management team for any final remarks.

[Dan Chard:]

Well, thank you everybody for joining us tonight. We appreciate all your interest and your participation in today’s call. Tim and I look forward to speaking with you again when we report our fourth quarter and fiscal 2019 financial results. Have a nice evening.

[Operator:]

And thank you, sir. Today’s conference has now concluded. We thank you all for attending today’s presentation. You may now disconnect your lines and have a wonderful evening.