Medifast, Inc. (MED) Q3 2014 Earnings Report, Transcript and Summary

Greetings, and welcome to the Medifast Third Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Katie Turner of ICR. Thank you. You may begin.

Good afternoon. Welcome to Medifast's Third Quarter 2014 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, 2014, that went out this afternoon at approximately 4:05 p.m. Eastern Time. If you've not received our release, it's available on the Investor Relations portion of Medifast's website, at www.medifastnow.com. This call is being webcast, and a replay will be available on the company's website. Before we begin, we would like to remind everyone that the prepared remarks contain forward-looking statements, and management may make additional forward-looking statements in response to your questions. The words believe, expect, anticipate and other similar expressions generally identify forward-looking statements. These statements do not guarantee future performance and, therefore, undue reliance should not be placed on them. Actual results could differ materially from those projected in any forward-looking statements. Medifast assumes no obligation to update any of these forward-looking projections that may be made in today's release or posted on its website. All the forward-looking statements contained herein speak only as of the date of today's call. And with that, I'd like to turn the call over to Michael MacDonald, Medifast's Chairman and CEO.

Thank you, Katie. Good afternoon, everyone, and thank you for joining us. On today's call, I will provide you with a brief overview of our third quarter performance and an update on our strategic initiatives. Tim will review the financial results for the third quarter in more detail and discuss the fourth quarter and full year 2014 revenue and EPS outlook. I will then provide closing remarks, and we will open up the call to take your questions. I am pleased with our ability to deliver earnings per diluted share of $0.39, ahead of our guidance, which ranged from $0.35 to $0.37. Excluding extraordinary expenses of $1.6 million, or $0.08 per diluted share, which Tim will discuss in more detail, third quarter net income would've been $5.9 million, or $0.47 per diluted share. This reflects our team's continued efforts to optimize profits through careful management of the controllable aspects of our business. We were able to accomplish these results despite continued pressure on revenue in the quarter. Net revenue for the third quarter decreased approximately 14% to $74 million from $86.5 million in the prior year. This was slightly below our guidance expectations for revenue of $75 million to $78 million. As we mentioned in the last call, we continue to experience challenges, with new customer acquisition in what continues to be a softer consumer spending environment and a challenging weight loss environment. On last quarter's call, I discussed a number of exciting initiatives designed to drive revenue. And now I would like to provide you with an update of each of these key strategies. New product innovation is an important part of our 2014 business plan. As many of you know, at this year's Take Shape for Life National Convention in Anaheim, California, we introduced a number of new products in incremental categories to drive revenue. While initial adoption of these new products began in the third quarter, we expect adoption and implementation to continue in the fourth quarter and into the 2015 diet season. So far this year, we have introduced a line of delicious snack products, the newly expanded Flavors of Home product line, several varieties of mashed potatoes and our Habits of Healthy Sleep kit. At the end of the third quarter, we introduced a new gingerbread soft bake, a warm, soft cookie flavored with molasses and ginger, which we made available in time for the holiday season. Just last week, we launched our new digital tracking platforms: our Habits of Health Dashboard for Take Shape for Life, My Plan Tracker for Medifast Weight Control Centers and My Wellness Dashboard for Medifast Direct. These digital dashboards enable customers to track weight, food, water intake, exercise and many other elements, while also integrating activity trackers into this comprehensive and personalized technology platform. We're excited about our partnership with Fitbit, the leader in activity trackers, and we believe by offering a more robust multifaceted solution, our customers will be more successful in their weight management endeavors. In addition, we have a few exciting product launches expected in the fourth quarter. In effort to create a product that appeals to ingredient-conscious customers, we have developed 7 new products that have no artificial flavors, sweeteners or colors. These products are also formulated differently to support ongoing healthy-weight maintenance and will appeal to those who started with us for weight loss and have graduated to weight maintenance. They also appeal to those who are already at their healthy weight and desire nutritious and convenient options from the company that has clinically proven and science-backed solutions. These products will be accompanied by a new Healthy Living program, that is part of our ongoing efforts to increase customer longevity and introduce our products to new customers and new entry points. Thus far, health coaches and Medifast consumers have responded positively to our new product introductions, and we are proud that 2014 has been our largest new product innovation year in the history of Medifast. Our Take Shape for Life channel represents our largest revenue stream and is the key driver of revenue profit and cash flow growth. While you've seen a decline in health coaches this year, we've been working to identify areas of opportunity as we refine strategies to fuel future health coach growth. At our recent Take Shape for Life Sundance leadership event, we heard constructive feedback from our top field leaders in terms of what tools would help them grow their businesses. These health coaches also shared the importance of simplifying the process of becoming a health coach or client. Based in part on feedback like this, we developed the BeSlim Club, which was launched at the convention, and provides benefits to clients or coaches who opt for our easy, automatic monthly shipping program. This program entitles members to special benefits, including preferential or free shipping; new introductory kits that make it easier financially to get started on the plan; and new rewards designed to provide ongoing incentives to aid in client retention. While still early, we are pleased to see revenue retention improvements over the first few months of the program. We believe these changes will continue to help with both the conversion of first-time buyers and increased client retention. In the third quarter, our Take Shape for Life division hosted the second Annual National Discover Your Optimal Health Day. The purpose of this day is to encourage a lifestyle of healthy eating habits and regular physical activity. Health coaches across the country hosted walking events in happy -- Healthy Happy Hours in their local communities. Take Shape For Life held more than 100 walks with more than 4,000 participants. We believe in the importance of teaching people how to live a healthy and active lifestyle, and we look forward to continuing to make Discover Your Optimal Health Day an annual tradition. In today's busy world, more and more people are reaching for their phones, computers and tablets to absorb content. This is why we launched our new Take Shape For Life virtual video support initiative. This initiative is comprised of 2 video series that provide digital tips directly to both new clients and coaches via email in order to improve engagement and understanding of the program. The client version of these videos is an excellent complement to the guidance our coaches provide and helps ensure a consistent and professional message to new clients. The video support initiatives for coaches is designed to guide new health coaches or health professionals to jumpstart their Take Shape For Life businesses. As many of you know, we continue to actively search for a new Take Shape For Life President to lead this channel, and have several outstanding candidates. We hope to provide you with an update on this appointment very soon. In the third quarter, we saw a decline in revenue in our Medifast Direct channel. This is a trend we have seen through fiscal 2014 as we continue to limit spending based on lower efficiencies and our desired optimized profitability. We are continuing to utilize our econometrics model to optimize our media mix across television, digital, direct mail and e-mail and continue to hone in on our key learnings across customer acquisition, retention and reactivation. The Medifast Advantage program, which brings an enhanced offer to drive customer acquisition as well as ongoing benefits for repeat orders launched in August. We'll continue to drive this offer via our media messaging. While ad spending was down 22% in the third quarter versus quarter 3, 2013, we are maintaining our plan to spend up in the fourth quarter on a year-over-year basis. The spending in quarter 4 will help position us for success as the diet season begins in 2015. Historically, our spending has an impact beyond the quarter in which it is spent. We believe the improvements we have made will help customer conversion and improve retention. The appointment of a focused leader for Medifast Direct also represents an important step to return this channel to growth while we're executing our ongoing strategic initiatives. This past Monday, we announced the appointment of Kenneth Kopp as Vice President of Medifast Direct. Ken will be responsible for Medifast Direct response channel, and has more than 20 years of direct-to-consumer experience, including several years at Guthy-Renker, one of the largest direct response firms in the world. He has helped grow many notable companies, including: Warranty Corporation of America, a division of Asurion Corp; Western International Media, where he worked with the clients such as Verizon, Toyota Motors, MCA Universal and Tyson Foods. Ken will report directly to Meg Sheetz. Medifast Weight Control Centers. We continue to make progress in our conversion of company-owned centers to the franchise model. We successfully transitioned 24 corporate centers in June to new franchisees. Unfortunately, 4 franchise centers, which opened in early -- in 2014 closed in the third quarter. These centers were unable to reach their financial objectives in their first year of operation. We have 51 corporate-owned centers and 69 franchised centers in the channel at the end of the third quarter. We remain focused on the transition of our centers to the franchise model and continue to take measures to improve the profitability of this channel. In April, we launched our new Fit in 4 programs in centers, which I discussed in last quarter's call As a reminder, this new program allows the customer to try a 4-week program at an attractive price point, with a goal to transition them to a longer-term program at the conclusion of the 4-week period. As expected, we saw a significant increase in client acquisition resulting from the program. However, thus far, we have not seen the level of full-program conversions we were targeting. We will continue the Fit in 4 program into the fourth quarter, while we attempt to improve retention of those opting for this program. To help improve the creative messaging and value proposition for each Medifast sales channel, in October, we announced the selection of GKV as our new marketing agency. GKV will work with our team in the development of the 2015 multimedia campaign, and we will tap into a comprehensive set of GKV's in-house capabilities, including market research, strategic planning, branding, creative development and direct response. We are thrilled to have GKV onboard and especially like their proven track record of building challenger brands, and we are confident they will add tremendous value across our entire business. Although revenue fell short of our expectations, we have made significant progress on many of our key initiatives. And I'm confident we are putting the right strategies in place to generate future growth as we prepare to enter the 2015 diet season. Before turning the call over to Tim, I'd like to reiterate that cost discipline continues to be an important component of our strategy to maximize profitability. And I'm pleased with our accomplishments thus far this year. Looking ahead with 2015, our internal team is focused on each of our sales channels and functions in an effort to reaccelerate growth. Some of these processes have already been put in place, and are yielding positive results. With that overview, I would like now to turn the call over to Tim Robinson, our Chief Financial Officer, to review our third quarter 2014 financial results and guidance for the balance of 2014.

Thank you, Mike. I'll now review our financial results for the third quarter ended September 30, 2014, in more detail. For the third quarter, net revenue decreased 14% to $74 million from net revenue of $86.5 million in the third quarter of the prior year. The Take Shape For Life sales channel accounted for 68% of total revenue, Medifast Direct accounted for 18% and Medifast Weight Control Centers and Wholesale Physicians accounted for 14% of total revenue. I'll focus in on our sales channels in more detail. Revenue in the direct sales channel, Take Shape For Life, decreased approximately 11% to $49.9 million compared to the same period last year. The decrease in revenue for this channel was primarily driven by a decrease in the number of health coaches, along with a decline in the revenue per health coach. We ended the third quarter with approximately 10,200 active health coaches, and the average revenue per health coach per month during the quarter was $1,504. Take Shape For Life commissions expense, which is variable based upon product sales, decreased by approximately $4.5 million compared to the third quarter of 2013. We're now 3 quarters into our new compensation plan, which was strategically designed to reward those who are currently coaching clients and growing their businesses. We expect our new product launches will contribute to an increase in revenue per health coaches as they roll out. Our Medifast Direct segment revenue decreased 22% to $13.4 million as compared to $17.2 million in the third quarter of 2013. Overall advertising expense decreased $1.2 million or 22% versus the prior year third quarter. Our team continued to focus on efficiency improvements and balancing sales and marketing spends in an effort to drive profitability. In the third quarter, the Medifast Weight Control Centers and Wholesale Physicians channel revenue decreased 20% to $10.6 million. As many of you know, we made the strategic decision to increase the profitability of the Weight Control Centers and, as a result, we have closed 11 centers since the first quarter of 2013. We also completed the sale of 24 centers to new franchise partners in the second quarter of 2014 as part of the company's long-term plan to transition corporate-owned centers to franchise locations. As of September 30, 2014, we have 51 corporate-owned centers and 69 franchise centers. Going forward, we will work to transition more of our corporate centers to the franchise model, while we evaluate the viability of our weakest-performing locations. Gross profit for the third quarter of 2014 decreased 15% to $54.9 million compared to $64.9 million in the third quarter of the prior year. Our gross profit margin decreased 80 basis points to 74.2% versus 75% in the third quarter of 2013. The decreases in gross profit margin was primarily due to 3 factors: lower volumes, the combination of sales mix resulting from transitioning 24 centers to the franchise model, and the introduction of several incremental products, which are sold at lower margins such as our Flavors from Home. Selling, general and administrative expenses in the third quarter of 2014 decreased $8.5 million to $49 million versus $57.5 million in the third quarter last year. Despite incurring a $1.6 million extraordinary legal and advisory expense in the quarter resulting from recent 13D filings. A significant portion of our SG&A expenses are variable, and our team has done a nice job managing discretionary spending. Selling, general and administrative expense as a percentage of net revenue decreased 30 basis points to 66.2% from 66.5% in the third quarter last year. Our effective tax rate was 29.1% compared to 28% in the third quarter of 2013. Tax rate for the quarter reflects a tax benefit for certain research and development credits related to the recently enacted tax regulations applied to prior years. Third quarter net income was $4.9 million, or $0.39 per diluted share, compared to net income of $5.7 million, or $0.41 per diluted share, in the third quarter of 2013. Excluding the extraordinary legal and advisory expenses mentioned earlier, third quarter 2014 net income would have been $5.9 million, or $0.47 per diluted share. The company's balance sheet remains strong, with stockholders' equity of $82.6 million and working capital of $51.7 million as of September 30, 2014. Cash, cash equivalents and investment securities for the third quarter of 2014 decreased $12.2 million to $55.6 million compared to $67.8 million at December 31, 2013. The company repurchased 676,092 shares of common stock for $19.7 million during the third quarter, in an ongoing effort to create value for our shareholders. On September 16, 2014, our board authorized the repurchase of an additional 1 million shares. As of September 30, 2014, there were 1.2 million shares available for future share repurchase under our repurchase program. The company remains free of interest-bearing debt. Our management team and Board of Directors remain focused on options to increase shareholder value, including utilization of free cash flow to buy back future shares. I'll now share our guidance for the fourth quarter and the full year. We expect fourth quarter 2014 net revenue to be in the range of $69 million to $73 million and earnings per diluted share in the range of $0.31 to $0.34. Our guidance includes $0.5 million, or $0.03 per diluted share, for the previously mentioned extraordinary legal and advisory expenses. In addition, fourth quarter guidance reflects the impact of a franchisee's announcement to close 7 centers at the end of October, and an anticipated franchisee loan default whereby Medifast is a secondary guarantor. Upon the triggering event of the franchisee loan default subsequent to September 30, 2014, we may be required to perform under the guarantee, resulting in a charge of up to $2 million, or $0.11 per diluted share. Excluding these 2 items, our earnings guidance is in the range of $0.45 to $0.48 per diluted share. The fourth quarter guidance also assumes a 33% to 34% effective tax rate. For the fiscal year 2014, we now expect revenue to be in the range $310 million to $314 million, and earnings per diluted share in the range of $1.59 to $1.62. The updated earnings per share guidance reflects $2.1 million, or $0.11 per diluted share, with the extraordinary legal and advisory expenses from the third and fourth quarters, and up to $2 million, or $0.10 per diluted share, of anticipated expense associated with the franchisee loan default mentioned above. Of note, there's a $0.01 difference due to the rounding for the impact of fourth quarter and the full year from the franchise loan default above. Excluding these 2 items, our earnings per share guidance is in the range of $1.80 to $1.83 per diluted share, in line with our original earnings outlook for 2014. The fiscal year 2014 guidance assumes a 33% to 34% effective tax rate. Well, that concludes our financial overview. Now I'd like to turn the call back over to our Chairman and CEO, Mike MacDonald.

Thanks, Tim. At Medifast, we believe that being the best place to work is imperative in attracting talent our organization and retaining employees who excel at their jobs. Early this year, we conducted an employee engagement survey and we'll continue to focus on both the things we are doing very well and those areas where we can continue to improve as we aspire to the highest level of employee enablement, engagement. In the third quarter, we also gave $100,000 grant to The V Foundation for Cancer Research, one of the nation's leading cancer research funding organizations. Cancer, in one way or another, has affected us all. And at Medifast, we recognize the importance of research to learn more about cancer prevention and treatment. This grant is a product of a multifaceted partnership between Medifast and The V Foundation to explore links between obesity and cancer, and the impact of healthy living on preventing cancer. The focus on disrupted sleep, which is often associated with obesity, is the first step in looking at some of the factors that may contribute to cancer. As you may know, we recently launched a series of sleep products in Take Shape For Life to help address this important habit of health. In closing, we believe our strategic initiatives will help fuel future growth across our multiple sales channels and improve our ability to attract new clients and retain our existing customers. Our team remains focused on prudently managing the controllable aspects of our business to increase profitability and strengthen our balance sheet, while delivering consistent shareholder value. We would now be open to any questions. Operator?

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

A couple of questions. First, the 11 franchise stores that are -- have closed, the 4 that closed, and 7 more announced in late October, where are they located? These aren't the 11 stores you sold to Medex or...

No. These were located in the state of Washington and also down in the Southeast in the U.S.

Just for clarity, so the 11 -- there's 2 references to 11. So in 2013, we closed 11 of our own stores. So on a year-over-year comparison, that is mentioned. The stores that -- if you look at our current franchise number of stores, we mentioned 69. That 69 reflects 4 store closures in the franchise world that opened on the West Coast earlier this year. We also referenced, not included in our number as of September 30, we referenced the closure we just learned about of 7 stores down south, which is -- are in process right now. They're franchise stores.

Is that a recent 7 stores that you had refranchised? Or have these been open for a while?

These were new locations, Scott. They weren't Medifast transfers.

Yes, these are -- one of our franchisees is expanding, and these are some of his expansions that did not work out appropriately or effectively.

Okay, okay. And -- all right, I just figured, if you were the guarantor on his debt, I would've assumed that it was -- you sold the stores to him or her or what have you.

He's had -- he's been one of our operators for many, many years. And so this was just his expansion agreement with us.

Okay, great. And then on ad spending, obviously, you pulled back relative to where you thought you'd be in Q3, given the environment. Now going into Q4, what's the plan? Is it to kind of tiptoe in and see if the market's open for acquiring customers?

Well, let me tell you what happened in Q3, Scott. One of the things we saw was even with these new people trying to open more of the franchise locations, they spend extremely heavily in advertising and did not see the appropriate returns. So we did adjust somewhat ourselves, seeing what was going on in the marketplace. But our intent is to spend up year-over-year in the fourth quarter significantly. So we do want to spend up in the fourth quarter significantly, and then go into the diet season with our whole new ad approach with our new agency with a major program. We feel good that we have a new person doing Med Direct, the new agency working with Brian Kagen to drive a whole new program. So that's our strategy. So we're not going to be reducing the spending year-over-year in the fourth quarter.

Okay. So even if the returns are unfavorable, this is really spinning ahead and getting ready to go in Q1, right?

Yes, this is us getting ready for the first quarter. So whatever we spend in the fourth quarter, we're acknowledging, may trickle into benefiting the first.

Okay, okay. And then the further declines in health coach count, can you expand on that, and kind of the thoughts there? I know you're working on plans to try and reverse it, but what's the field telling you?

Yes, I mean, the field right now is just heads down and focused on continuing growth. And then, we had an event -- a leadership event in Sundance in October. A lot of the communication there was what we worked on together, both field leadership and corporate, was how do we create and simplified system that includes more of the support infrastructure in the company. So we've done a lot of -- you've heard me talk about simplification for a couple of years now. We've done a lot of simplification from a training and development aspect. We need to do some on the infrastructure side. So that was a big topic, which will be part of a huge strategy for Take Shape For Life in 2015. And we feel that our job is to make being a coach as easy as possible for a part-time person. For any of you who have tried to sign up as a coach, it can be a little cumbersome in that regard. So we continue to work at how to re-create that experience for a client to move into a coach.

Okay, great. And then last question's for you, Mike, calling out the expenses, the legal and advisory expenses on the shareholders, the active shareholders that are not involved. I'm kind of wondering what's the plan there. Or is something in process? I'm just wondering, spending $1 million on legal and advisory, is there a negotiation that's going on? Can you give us any further detail?

Well, basically, we're committed to improving shareholder value as a company. We've had an M&A committee in place since January, and we're really just making sure we're doing the right things to improve shareholder value. And as far as the 13D filers, we've had a constructive discussion with all of our large shareholders, like we always do, and it's been nothing but positive discussion. So that's basically all I can give you on that, Scott.

Our next question comes from Alec Jaslow with Midtown Partners. Alec I. Jaslow - Midtown Partners & Co, LLC, Research Division: Just was curious to hear how some of the products you rolled out early in the third quarter are doing so far. And also, if you could talk a little bit about how the Flavors of Home have done versus your expectations?

Yes, I would say right now that all of our product launches this year, the Flavors of Home, the snacks have all exceeded our expectations. We had initially put an attachment rate on those products and we would say that we're exceeding it. I think we're comfortable with saying that about 3.6% of revenue was the incremental revenue we're getting from the new categories that we've launched. So it's very exciting for us.

I think the other thing, I think, Alec, that's going to be a big positive is on November 18, we're going to launch our whole Healthy Living program for Medifast, which gives us a new 3, 2 & 1 plan, which would be called Thrive by Medifast, and we see this as really going into a maintenance area and more the Healthy Living, healthy alternatives. And we see that as a big positive to help us in the fourth quarter.

And I think what's exciting about the launch in November that we really wanted to get ready for diet season in January, is, one, the products are absent of [ph] negatives. Two, we have special packaging. So this new special packaging for Take Shape For Life has its own packaging. Medifast Direct has its own packaging. So one is called Thrive; one is called Optimal Health. It's very exciting for both of those divisions. Alec I. Jaslow - Midtown Partners & Co, LLC, Research Division: Okay. There's also -- maybe it'll be helpful to hear about some of the feedback you got from the new franchise -- franchises that were closed, maybe some of the issues, and things you're going to try to do to fix that going forward.

I think one of the issues that we've seen is where we've had established locations, whether they be company-owned or franchise locations, those locations are performing well in a difficult environment. Where we're seeing openings into new locations and trying to do that in this environment, it's been extremely difficult. And by the way, I'm talking about very heavy advertising spending, with people who are very good operators. These are not people who don't know how to run their business. They've been in this business a long time. So we've seen that it's been extremely difficult. And obviously, costs are going up in the advertising space and it's been difficult. And I think we made the appropriate decision trying to help a key franchisee expand and lending them the money to try to help them get there, because they'd been with us for years and years. And we've been attempting to really drive revenue. I mean, we've -- we were doing that. We were also putting a very aggressive BeSlim program to improve our order ship and our retention. So even though we cut a little bit back in advertising, we've been aggressive in other areas to try and get revenue. And that's really been sort of the approach, Alec. And these operators, they tried and they reached a point where they just said that it wasn't worth proceeding. And that's the -- I think that's the difficulty right now. And I think some of our competitors are seeing the same thing. Alec I. Jaslow - Midtown Partners & Co, LLC, Research Division: Okay. And then just the last question was I'd be curious if your conversations with Ken, the new Vice President at Med Direct, if -- what he thought should be done going forward? Or is he planning on making drastic changes overall? Or does he want to optimize advertising better? Any color you can give on that would be helpful.

Yes, so he's on his third day. So from a third-day perspective he has some very great ideas coming to fruition. Right now, it's about let's look at what we're currently doing and then what can we do by January for diet season to impact it. I think the team here has put together a great strategy to move us into the first quarter and help take part in that as well. But he certainly -- he definitely has -- he is a direct response expert, and so it's been a lot of -- the last 3 days have been exciting around here to change the way we think and really challenge ourselves to do some different things. So we're looking forward to it.

Yes, we're determined -- we're determined to bring in people who have the expertise, Alec, that we need to move forward. He's also very focused on measurements and some measurements that we're not doing today that he feels could be brought in. So I think our team has made progress internally, but now we've got to try to take this to the next level. And I think with Brian and Ken, we're in a good position now to move forward at both the advertising agency that we've hired and the direct response.

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

We appreciate your participation today, and we look forward to speaking with many of you in the coming months. We thank you very much for your support of Medifast.

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