Medifast, Inc.
Q3 2013 Earnings Call Transcript

Published: 6 Nov 2013

[Operator:]

Greetings, and welcome to the Medifast, Inc. Third Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Katie Turner, for opening remarks. Ms. Turner, you may begin.

[Katie M. Turner:]

Good afternoon. Welcome to Medifast's Third Quarter 2013 Earnings Conference Call. On the call with me today are Michael MacDonald, Chairman and Chief Executive Officer; Meg Sheetz, President and Chief Operating Officer; and Timothy Robinson, Chief Financial Officer. By now, everyone should have access to the earnings release for the period ending September 30, 2013, that went out this afternoon at approximately 4

[Michael C. Mac Donald:]

Thank you, Katie. Good afternoon, everyone, and thank you for joining us. On today's call, I will provide you with an update on our strategic initiatives and discuss areas of our business where we continue to work on generating efficiencies to improve Medifast's future growth and long-term profitability. Tim will review the financial results for the third quarter in more detail and discuss the full year 2013 revenue and EPS outlook. I will then provide closing remarks, and we'll open up the call to take your questions. In the third quarter, we remained very focused on reaching our profit objectives for 2013. I'm pleased to report earnings of $0.41 per share, in line with our guidance, which was in the range of $0.38 to $0.42 per diluted share. This result was achieved despite a challenging consumer spending environment, in which our sales for the quarter fell below expectation. During the third quarter, we closely controlled spending while monitoring our strategies to attract new clients and increase retention. We will continue to be disciplined to find the right balance to achieve growth and profitability across our Take Shape for Life, Medifast Direct, Medifast Weight Control Centers and Wholesale Physicians sales channels. I will provide an update on each of them for you today. Before I do that, I want to reiterate that our team has a comprehensive multiyear plan in place that we started when I joined the company, and we are continuing to refine the operational and strategic initiatives with a constant goal in mind

[Timothy G. Robinson:]

Thanks, Mike. I'll now review our financial results for the third quarter ended September 30, 2013, in more detail. For the third quarter, net revenue decreased 5% to $86.5 million from net revenue of $91 million in the third quarter of the prior year. Take Shape for Life sales channel accounted for 65% of total revenue. Medifast Direct accounted for 19.8%. Medifast Weight Control Centers and Wholesale Physicians accounted for 15.2% of total revenue. Gross profit for the third quarter of 2013 decreased 5% to $64.9 million, compared to $68.3 million in the third quarter of the prior year. Our gross profit margin decreased 10 basis points to 75% versus 75.1% in the third quarter of 2012. The small decrease in gross profit margin during the quarter is primarily the result of higher shipping costs. Selling, general and administrative expenses in the third quarter of 2013 were $57.5 million versus $59.4 million in the third quarter last year, a decrease of $1.9 million. As a percentage of net revenue, selling, general and administrative expenses increased 120 basis points to 56.5% versus 55.3%. Take Shape for Life's commissions expense, which is variable based on product sales, decreased by approximately $400,000, and our Take Shape for Life sales grew 1% compared to the third quarter of 2012. Sales and marketing expense decreased by $2.3 million in the third quarter as compared to the third quarter last year. Operating income was $7.3 million or 8.5% of net revenue compared to $8.9 million or 9.8% of net revenue in the third quarter of 2012. Our effective tax rate was 28% compared to 19.7% in the third quarter of 2012. The increase in the effective tax rate was primarily the result of state tax restructuring that took place in the third quarter of 2012, which helped us take advantage of state apportionment methodology. Third quarter net income was $5.7 million or $0.41 per diluted share based on approximately 13.9 million shares outstanding compared to net income of $7.2 million or $0.52 per diluted share for the comparable quarter last year. The company's balance sheet remains strong, with stockholder's equity of $111.3 million and working capital of $76.3 million as of September 30, 2013. Cash, cash equivalents and investment securities for the third quarter increased $22 million to $82 million compared to $60 million at December 31, 2012. As we communicated last quarter, the company paid off the remaining value of the outstanding long-term notes and remains free of interest-bearing debt. Now I'll review our guidance for the full year. We expect full year 2013 net revenue to increase 0.9% to 2.3% or in the range of $360 million to $365 million. While revenue guidance has been adjusted from the original annual estimates, our guidance for earnings per diluted share remains within our original estimate and as we enter the last quarter of the year, is narrowed to $1.70 to $1.75 per share. We believe that this is a testament to the operational improvements and strategic initiatives Mike spoke about to improve our overall long-term profitability. Our guidance includes our anticipation that the effective tax rate will be in the range of 33% to 34% for the year. That concludes our financial overview. Now I'd like to turn the call back over to our Chairman and CEO, Mike Mac Donald.

[Michael C. Mac Donald:]

Thanks, Tim. We believe our multichannel weight loss and weight management business model allows us to benefit from an overall more diversified go-to-market approach. In closing, we are pleased with our team's consistent ability to focus on delivering profit in 2013. Going forward, we remain intently focused on managing the controllable aspects of our business model, introducing initiatives to drive sales across our vertically integrated business model and delivering increased earnings and cash flow generation. Our Medifast team continues to be optimistic about the long-term growth prospects, and we continue to execute our strategic plan. We appreciate your interest in Medifast. And with that overview, Tim, Meg and I are available to take your questions. Operator?

[Operator:]

[Operator Instructions] Our first question comes from Scott Van Winkle with Canaccord Genuity.

[Scott Van Winkle:]

Quick question, 2 easy ones. Why was the tax rate lower? I didn't catch that if you said it. And then second, what was the other income? Was it $360,000 or something in the quarter?

[Timothy G. Robinson:]

Yes. So the -- Scott, the tax rate, really, in 2012, we went through a major tax restructuring in 2012, which basically took a lot of our earnings out of the State of Maryland and apportioned it amongst other states. So we were kind of mostly single-state tax in the past. So by spreading it out, basically, all that income goes into -- a lot of that income goes to other states, which don't necessarily have income tax. So it lowered our effective tax rate. So that was really why -- and a lot of that work was done in the third quarter of last year, so you'll see a little bit of a roller coaster last year in our tax rate during the third and fourth quarter. In this year -- our typical tax rate is 34% to 35%. This year, as we filed our final tax returns for last year, we had a true-up, knowing what the actual tax now is going to be based on that new methodology. And so our rate came down to 28% this year, which was really just that catch-up for -- kind of a true-up from last year's final return and then an adjustment to our accruals for the first, second and third quarter this year with the lower rates. So going forward, in the fourth quarter, we'll return back to normal rate, in the neighborhood of 34% to 35%.

[Scott Van Winkle:]

So Tim, if I look at -- and this not at all that significant. But the year-to-date tax rate -- and I may be calculating it wrong because I'm looking at my model rather than your GAAP results, the year-to-date tax rate, it looks like it's 31%, and it jumps up in Q4. Is that right?

[Timothy G. Robinson:]

It will jump back up a little bit in Q4. So our rate is going to be -- on a full year basis, it's going to be somewhere -- we estimate it in the 33% to 34% range, probably on the lower side of that, when we finish up the fourth quarter.

[Scott Van Winkle:]

Okay, cool. And then the other income? Is that from the investments?

[Timothy G. Robinson:]

Yes. So we have some investment income that rolls into other income, and our investment portfolio is a little bit bigger than it was a year ago. And last year -- the third quarter of last year, other income was extraordinarily low. It's not typical so, from a year-over-year comparison, it was a little bit hard. If you look at our third quarter, we're a little higher than our prior quarters but kind of in line with the first couple of quarters of last year. So it's really the year-over-year comparison is nothing that abnormal.

[Scott Van Winkle:]

Yes. And a lot of people are interested in your buyback activity or opportunity to buy back. So are -- the investment securities on your balance sheet, are they liquid? I mean, is all of that kind of a war chest, so to speak, that you could spend near term, if you wanted to, in share repurchases?

[Timothy G. Robinson:]

Yes, absolutely.

[Scott Van Winkle:]

Okay, great. And then, a couple of kind of business questions. So it's always the question of spending versus sales, kind of the chicken or the egg question of which comes first. The advertising spend being down, was -- I mean, it sounds like that's the reflection of the market environment, you pulled back when you saw spending. How should we think about which one proceeded which, kind of the environment or the ad?

[Michael C. Mac Donald:]

Yes. Here's what happened, it was really the environment, Scott. We went out and we looked at, example, our clinic owners, and they spend, as you know, significantly higher amount than even we do, and they were having less effectivity attracting new customers. By the way, similar to us, in that clinic business. So basically, we spent a lot of time talking to them, and then looking at our own activity before we made any decisions. And even though on the Med Direct, after we had cut spending, we put $1 million back in just to see -- even though the number was low, we might have even cut more or we put more money back in, being that we wanted to just see what was happening in market, and we saw less efficiency from the spending than we would have liked. So we basically made the decision to say, "Let's really focus on optimizing the profitability and then move back more Med Direct to our 3 warrant [ph] philosophy that we've always had in January." So we just wanted to make sure. Because we -- where we saw consumer spending, some of the tax law changes and the government furlough as having an impact on our revenue because you saw we went from 8% in the first quarter to 4%. And by the way, when you look at us overall, we're going to be up for the full year, where our 2 biggest competitors are down 14% and down 6%. So I think we've managed to make the full -- be positive at least for the full year in what we see as a much more difficult environment but do it in a way where we could still make the EPS guidance that we gave in the beginning of the year and improve our cash flow. So that was really sort of the decision, but it really was looking at the market very intently first before we did any cuts.

[Scott Van Winkle:]

Yes. Yes, I mean everybody's seeing the Weight Watchers is a little softer. I don't think anybody's too focused on the Med Direct in the near term. I guess, the 2 questions I would have are, one, kind of what's planned for '14? Is there something bigger, better, bolder, et cetera, et cetera, et cetera on the Med Direct side, where you can spin it against the program? And then second -- and these are 2 very unrelated questions, I apologize, and then I'll yield before [ph] is on the Take Shape for Life, obviously, what we're all focused on is the majority of revenue. I'd love to hear some commentary about the revenue per health coach and maybe what the trends are there, what you expect. I mean, you saw pickup in coach growth, so we'd expect productivity to fall a little bit, but now we're kind of 2 quarters into that.

[Michael C. Mac Donald:]

Yes. Let me talk about -- I'll hit Take Shape for Life first. Take Shape for Life, we anticipate over the full year growing about 7%. By the way, if you compared us to Herbalife and some of the other people who are in multilevel, in the U.S. revenue growth, pretty consistent. And being on the board of DSA, the average DSA company is growing at 4%. So Take Shape for Life is really going to have a decent year related to the DSA space. What hurt us really was 1 month. We had a terrible month in the month of August, Scott, in Take Shape for Life. So the 1 month really was low relative to what Take Shape for Life normally does. And what we -- there could be different causals to that. But we had our big convention in July. We think we had a lot of people out of the field in the month of August, whether it was extending their trips, being away. But for some reason, we really had an anomaly in August that we felt was significant. It came back in September and improved from where we were, but that was probably the biggest hit that we took from a Take Shape for Life standpoint because we were fairly confident we'd see about 10% growth for the year. And we saw that hit happen, and we see them growing about 7%. So Meg, why don't you add any color to Scott's question.

[Margaret E. MacDonald-Sheetz:]

Yes. Just we are seeing -- particularly with the new integrated compensation plan launch, we are seeing more people go -- increasing in rank. People are moving through the ranks faster than they were in previous months, which is a good sign for the future. So we are happy with the September. August, as Mike said, was an anomaly.

[Michael C. Mac Donald:]

Yes. We also grandfathered a lot of these people, Scott, on the compensation. So we're not getting any negatives on the compensation plan from the network, but we did see a very poor month in August.

[Scott Van Winkle:]

Yes. Meg, do you think there's any potential kind of short-term disruption associated with the new compensation plan that you would have seen in August?

[Margaret E. MacDonald-Sheetz:]

The only thing is if you ask the field what their response would be to August, they would say that, to some degree, they were working on structuring their teams for success. We don't feel like there's any major business interruption. We really do feel -- we had 12 events this year compared to 3 that we typically have. Most of those events fall in the third quarter. So we certainly will not repeat that next year and the field agrees with that. So again, we're not -- we feel like we may have taken them out of the field, and that may have been more impactful than even the comp plan itself.

[Scott Van Winkle:]

Got you. And then on the Med Direct, as you know, we're 1 month into November, kind of what the plans are, what the new program is going into the diet season in Jan 1?

[Michael C. Mac Donald:]

Yes. We have a lot of different program -- on the Med Direct side, we're working very closely to refine the things that are going on into Med Direct. But let me tell you, we have significant plans for a new maintenance line, technology, snacks, Lean & Green Meals, beverage mixes, condiments, supplements, so we're going to have the most extensive launch of products next year, Scott, in the history of Medifast. And we've been working a lot of these different areas, and we see great opportunity there. And what we're going to do is really, as we launch our new products, we'll combine an Investor Day with a product launch and an overview of all these things early in the year. We're going to do that. That would be up in New York.

[Operator:]

Our next question comes from John San Marco with Janney Capital Markets.

[John P. San Marco:]

You referenced the key metrics that you are monitoring that motivated you to pull back on the Medifast Direct marketing during the quarter. Can you highlight some of those metrics that maybe were materially different than what you had expected and go into what's driving that?

[Michael C. Mac Donald:]

Well, John, one thing I think we looked at is, I think, it was something -- if I look at the year over again, we spent about $8 million in branding in the beginning of the year, and I think that it helped us raise our brand awareness from 20% to 40%. So it was a time we needed to make investments. But if I could have anticipated the economic slowdown, I probably would have done demand generation from the start of the year, with our close rates on that brand advertising, bringing people to close -- brand advertising isn't as good as demand generation advertising. So we spent a lot in the first half of the year on that, and I think that didn't give us as much spending flexibility as we'd like to have in the second half of the year, given we wanted to make sure we achieved our aggressive profit growth targets. So I think, when we try to balance the 2 of them -- and we're working with -- and I think that was one of the big issues, was the closure. We talked about that in the first half of the year. But even with the demand generation in the -- we've seen the closure rate being more difficult than we had in the past. So that's clearly a question. And we have held our pricing and our margins and all those kind of things. And by the way, thank god we did because we've got very positive results. What we would have lost in buying, we made up for in pricing and margin in terms of the profitability of the company. So we had to make some tough decisions, and that's really what we're doing. We're working very hard right now, working on improving our Internet site, working on mobile applications, a lot of technology things to get ready for the diet season to ensure, as we reengage heavy spending -- you can be assured, though, the heavy spending will be more demand generation type spending as we move into the diet season. Then, obviously, there'll still be branding, but we want to make sure that we're focusing on generating orders on the website and not just building our brand.

[John P. San Marco:]

Okay. And then, I'm sorry, I missed or didn't fully understand your comments on the month of August. It sounds like it was sort of extraordinarily weak relative to July and September. What are your thoughts on what drove that again?

[Margaret E. MacDonald-Sheetz:]

Basically, in August, we had a couple of things happen. Obviously, we have our convention for Take Shape for Life late in July, which initiates countrywide travel at that time. But we had about 12 events this year, quite a few of them falling into the third quarter that typically in Take Shape for Life we have about 3 events a year. So that is significantly different. We will not repeat that for next year. We'll go back to having our 3 events that we sponsor as corporate next year. So we did have an anomaly in August. We felt like between the travel and then the field kind of rearranging their teams to get ready for the integrated compensation plan launched on September 1, that's probably why there is an anomaly in August, but we recovered in September. And I haven't heard, really, anything other than they're happy to be growing and moving forward. We're actually seeing more people rise through the ranks, and that's a good sign for the future.

[John P. San Marco:]

Got it. And just to be clear, when you say events, you're talking about typical training and motivational events you hold?

[Margaret E. MacDonald-Sheetz:]

This past year, we did a bi-city tour to increase the whitespace -- decrease the whitespace on the map and get Take Shape for Life out there. Certainly, that effort did work, but it did take a significant number of field leaders in specific areas, which, to us, is probably not the most effective use of their time. So we'll rethink that and re-strategize that moving forward.

[Operator:]

Our next question comes from Kurt Frederick with Wedbush.

[Kurt M. Frederick:]

Just a question on the depreciation expense. I think you closed 3 centers during the quarter. Was wondering what depreciation will be going forward.

[Timothy G. Robinson:]

Well, depreciation on those 3 centers is not that significant, just on 3 centers. The total asset value of the centers are not that great. They also were at the end of the lease so a lot of the assets were already fully depreciated. So just those 3 centers I wouldn't say it's anything material. Within the med -- MWCC operation, there's, I guess, one relatively significant amortization expense, which fully amortized off in the third quarter, which has about roughly a $30,000 per month expense that will disappear after September. So that's a real positive, but that was an intangible amortization from years ago. So that's one positive.

[Kurt M. Frederick:]

Okay. Are there any other centers planned for closure?

[Timothy G. Robinson:]

We're evaluating that, Kurt, as to the centers that we need to close. And we'll be announcing as soon as we close some of the sales of the centers, when we close them. And then we'll also decide if we need to shut anything down.

[Kurt M. Frederick:]

Okay. And then on Medix, kind of what does that have in total contribution to your sales at this point?

[Michael C. Mac Donald:]

I don't have the exact number for Medix, but we expect the contribution to be -- to improve quite a bit between now and next year. So example, they've opened our first center in Mexico City in a really nice area. They're opening a second, and they're looking at other opportunities to expand their clinic business. So we feel very comfortable. They're getting better. Remember, they're a pharmaceutical company that was used to selling pharmaceuticals through doctors, and that takes a while to do that. We went through years and years and years trying to use just doctors to grow Medifast. So they're moving quickly through the clinic model. We're also doing corporate wellness with the executives in Mexico and expanding into the corporate areas. So we feel very comfortable that as we move forward in the next couple of years, the revenue will get meaningful. But remember, they're not a GE. There is a company like a Medifast in Mexico, and it takes time to get moving, but we feel good about the progress we're making. In fact, they'll be here this weekend in Owings Mills to work with us further on their strategy.

[Timothy G. Robinson:]

I think the best way to categorize Medix at point is this year was a year of them organizing structure, getting the food approved in multiple countries and establishing an organization there to manage the clinic models that Mike said they weren't used to. So I think that the revenue contributions really this year are light. But the revenue will come through the clinic. So as they expand, that's where we see the revenue growth coming from.

[Kurt M. Frederick:]

What markets are they operating in right now?

[Michael C. Mac Donald:]

They're in Mexico right now, and they've opened Colombia. And they're opening Argentina. So they're going to be in Mexico, Colombia and Argentina. They're the first 3. Plus the good news, they're also paying the expense as they enter those markets.

[Operator:]

[Operator Instructions] Our next question comes from Michael Halen with Sidoti & Company.

[Michael Halen:]

Can you talk about how many franchise units you expect will be opened in the fourth quarter?

[Michael C. Mac Donald:]

Franchise units in the fourth quarter, 5. There's supposed to be 5 that are going to open, and they're basically ones in the South, Southeast United States.

[Michael Halen:]

Okay, great. And I think you mentioned that ad spending was $5.5 million in the quarter. And you may have mentioned it, if you did, I missed it. What is ad spending in the year-ago period.

[Michael C. Mac Donald:]

[indiscernible] What was that?

[Michael Halen:]

What was the ad spending in the year-ago period, in the third quarter of 2012?

[Michael C. Mac Donald:]

Tim, you can take that one.

[Timothy G. Robinson:]

One of the things, Mike, on the franchise agreements, we assign 3 development agreements with our 3 top franchisees multiyear agreements that will be executed as we move to the end of this year. There's 5, that's part of that. So 5 will go in this year, and then more in the first quarter of next year.

[Michael Halen:]

And how many units does that cover?

[Timothy G. Robinson:]

I think we are probably looking at probably 9 units in the first quarter. It's a total of about 14 between the beginning of the year...

[Michael Halen:]

And you said that would be -- and so 5 in the fourth quarter this year and 9 more units, did you say, in the first quarter next year?

[Michael C. Mac Donald:]

First quarter next year, yes. That's the plan that we have so far.

[Michael Halen:]

Okay, great. And, Tim, did you have that number, your ad spend from the third quarter of '12?

[Timothy G. Robinson:]

Yes. Total advertising in the third quarter of '12 was about -- add a few lines here. It's just advertising. But advertising, by itself, was about $7 million, just to that degree. The lines...

[Operator:]

We have a follow-up question from Scott Van Winkle with Canaccord Genuity.

[Scott Van Winkle:]

Did I hear some commentary about clinic profitably? And if I did, could you repeat it?

[Timothy G. Robinson:]

Well, the question was about depreciation expense. We closed 3 clinics at lease expiration. And so the question was, was there a significant depreciation associated with those clinics, and the answer is no. Specifically, with those closures, there is not. In the total clinic model though, there was some amortization of some intangibles dating back years that ended in the third quarter of this year, and that was in the neighborhood of $30,000 per month. So in the aggregate there is an improvement going forward of about $30,000 a month but not specifically associated with the 3 clinic closing.

[Scott Van Winkle:]

Got you. I was thinking, in that prepared remarks something about improvement in clinic profitability. But anyway, could you...

[Timothy G. Robinson:]

Yes. We had improvement in the profitability for sure. So there's a slight improvement on profitability quarter-over-quarter even on the reduced sales. Our company clinic's same-store sales have declined. Our franchise business is up, and that combined segment profitability is up.

[Scott Van Winkle:]

Got you. And I know we can certainly get it out of the Q when the Q comes. But do you have any figures available as far as the contribution you report out in the Q for the clinic business relative to last year?

[Timothy G. Robinson:]

Yes, I believe -- and I'll recall it real quickly. I believe the profitability improvement was in the -- it was about $140,000.

[Scott Van Winkle:]

$140,000. And when we think about -- a lot of investors have kind of done the math, okay. You sell your company-owned clinics, you end up selling product, you get the gross margin on the product sales, the franchise fee, et cetera, yada, yada, yada. I'm wondering, when you do your segment analysis, what kind of cost accounting is there as far as -- when I look at your Qs and Ks and I look at the profitability of the clinic sector, how do we think about the gross profit you get from manufacturing the products sold to clinics? What I guess I'm getting at is, if I look at the company-owned clinics, are they less profitable than it looks in that segment analysis, if I consider you getting maybe a 50% gross margin on selling products to those clinics? Do you get where I'm going with that?

[Timothy G. Robinson:]

Yes. So on the company-owned clinics, they're basically -- their cost of goods is basically equal to manufacturing cost. There's no step-up cost for them. Their margins in the company-owned clinics are very high based on the retail price versus manufacturer's standard cost, as well as they have revenues in there that are associated with services that we provide, counseling services, which essentially come in at 100% margin in that line. So we have very high gross profit margin, but we carry a very high SG&A in our company-owned clinics. In the franchise model, we don't carry any SG&A really. But our margins in that model, depending -- we have scale depending on volume, but anywhere from the 40% to 50% gross profit margin range, but carry no SG&A with that. So the franchise model tends to -- it does have a higher contribution margin in the profit than the company-owned clinic models, because the net between that higher margin and the SG&A in the company clinics is a much smaller contribution than the franchise.

[Operator:]

Our next question comes from Michael Halen with Sidoti & Company.

[Michael Halen:]

If you could just update us about what you're looking to do with the cash, I'd appreciate that.

[Timothy G. Robinson:]

Did you say cash, Mike?

[Michael Halen:]

Yes.

[Timothy G. Robinson:]

So we said, I know, on a number of other calls, that this was really a year for us to kind of evaluate a number of strategic options as far as how we're going to grow the company, vertically and otherwise. So we haven't gone through that process this year. So at this point, nothing new to report on that. We've also been asked the question about the stock buyback, and we continue to kind of stay the course with that. We do intend to do share repurchase this year. So that's really the update on cash at this point.

[Operator:]

[Operator Instructions] There are no further questions in queue at this time. I would like to turn the call back over to management for closing comments.

[Michael C. Mac Donald:]

We appreciate your support at Medifast and your participation on today's call. We look forward to providing you with an update on our business when we report results for the fourth quarter and full year of 2013. And also, as I mentioned, when we set up an Investor Day and product presentation in New York. Thank you very much.

[Operator:]

This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.