Good afternoon and welcome to the Medifast Incorporated Third Quarter 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation there'll be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Katie Turner from ICR. Please go ahead.

Good afternoon. Welcome to Medifast's third quarter 2016 earnings conference call. On the call with me today are Michael MacDonald, Executive Chairman; Daniel Chard, Chief Executive Officer; and Timothy Robinson, Chief Financial Officer. By now, everyone should have access to the earnings release for the period ending September 30, 2016 that went out this afternoon at approximately 4:05 PM Eastern time. If you've not received the 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 I 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 forward-looking projections that may be made in today's release or posted on the call on its website. All of 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 Medifast's Executive Chairman, Michael MacDonald.

Thank you, Katie. Good afternoon, everyone, and thank you for joining us. Today, I will provide a brief introduction. Then Dan will discuss our third-quarter performance and an update on our strategic initiatives. Tim will review our quarterly financial performance and guidance for the remainder of 2016. Finally, we will open the call for your questions. Our strong business momentum continued in the third quarter, resulting in financial performance above expectations. Over the last several quarters, our team's efforts have been focused on highlighting our value propositions to health coaches, partners, clients, and customers. Medifast's operational and financial success reflects the ongoing progress we've made to build upon our strong foundation. At the same time, we have made key strategic investments in additional talented executive leadership who will contribute to sustainable revenue and profit growth moving forward. We are at an exciting point of transition. We believe the business is very well-positioned for future success. Most recently, we were fortunate enough to gain a seasoned executive in Dan Chard with his appointment as Chief Executive Officer. I, along with other members of our Board and management team, have the pleasure of getting to know Dan since he started in early October. Dan brings an outstanding background. He joins us with extensive experience in direct selling, having spent over 15 years at Nu Skin Enterprises in various leadership roles, including Executive Vice President of Distributor Success, then President Global Sales and Operations, and President of Nu Skin Europe. Most recently, Dan was President and Chief Operating Officer of PartyLite, an affiliate of a portfolio company of the Carlyle Group. This, along with a strong history in consumer products at the Pillsbury Company and pure recovery engineering, makes Dan ideally suited to help us take our business to the next level and accelerate our growth. Dan's unique combination of leadership skills across operational, international and marketing roles will be a tremendous asset to our team as we build upon the success of Take Shape for Life and further optimize our unique multichannel distribution model. Since I was appointed as the CEO of Medifast in early 2012, we have made tremendous progress advancing our strategic objectives and creating value for our stockholders. With our financial performance, strength of our balance sheet position, executive talent, momentum in Take Shape for Life, particularly with the recent OPTAVIA lifestyle brand and product line introduction, Medifast is truly in the strongest position in our Company's history. I look forward to working closely with Dan and the rest of the management team as Executive Chairman of the board, a role I'm proud to have held since November of 2011. My passionate for this business, our partners, health coaches, franchisees, customers, and employees remains as strong as ever. I would now like to turn the call over to Dan.

Thanks, Mike, for the kind introduction. It's great to be speaking with you today on my first Medifast earnings call. It's been just over a month since I joined in early October, and it's been an exciting start for me. I've already experienced the team's energy and enthusiasm around our long-term strategic growth initiatives focused on creating sustainable growth. Medifast is a company I have followed over the last several years. Our approach to product development and channel management has resulted in some of the best weight management and optimal well-being solutions in the industry. We have tremendous operational assets, compelling financials, and a strong executive team, three elements that create a solid foundation for future growth. For me, the opportunity was clear, to join a company at the beginning of a great point of transition where we can more fully leverage our existing resources and expertise, add a few key missing pieces, further strengthen our message across the business units, and simplify our operating as we support the next levels of accelerated sales, profit growth, and shareholder return. I'm excited about the future of Medifast. Now, let's get into our review of the third-quarter performance. The momentum that we had coming out of the first half of 2016 continued through the third quarter of the year. Take Shape for Life reported its second quarter of double-digit growth with revenue up 13%, representing the seventh consecutive quarter of improvement in the revenue growth and the highest level of year-over-year revenue growth for the business unit in three years. The efforts to better highlight the respective value proposition our business has offered to health coaches, partners, and clients and customers has helped drive our improved results, and I will discuss our strategic initiatives in more detail on the call today. Take…

Thank you, Dan, and good afternoon everybody. I'll now review our performance for the third quarter ended September 30, 2016. Please note that the financial information I reference today will focus on results from continuing operations. In the third quarter, net revenue increased approximately 4.1% to $68.6 million from net revenue of $65.9 million in the third quarter last year. The Take Shape for Life business unit accounted for approximately 82.4% of revenue. The Medifast Direct business unit accounted for 11.8%, and the franchise Medifast Weight Control Centers business unit accounted for 5.4%. And the Medifast Wholesale business unit accounted for 0.4% of net revenue. Expanding on our sales mix in more detail, revenue in the direct sales unit Take Shape for Life was up 13% to $56.5 million from $49.9 million in the third quarter of the prior year. This quarterly improvement in the year-over-year trending continued in the third quarter and we were pleased to have our fourth consecutive quarter of positive year-over-year revenue growth in Take Shape for Life. We're also very pleased to have double-digit growth in Take Shape for Life for the second consecutive quarter. There were approximately 12,800 active help coaches in the third quarter compared to 12,000 in the same period last year. Average revenue per active health, earning health coach for the quarter increased to $4,421 as compared to $4,145 in the third quarter of last year. We believe that our increased emphasis on key Take Shape for Life strategies, the increased engagement level of our field leaders, the operational improvements in the health coach experience, and the incremental resources added to the Take Shape for Life team are having a cumulative impact and have transitioned into momentum and will in turn drive sustainable growth. Our Medifast Direct segment revenue decreased 28%…

We will now begin the question-and-answer session. [Operator Instructions]. Our first question comes from Frank Camma with Sidoti. Please go ahead.

Congratulations on the quarter. Let's go a little bit more into the gross margin here because it was -- I went back all the way to 2008. I couldn't find anything that came above 76% gross margin. Maybe I picked that up wrong, but it looks like this is like the high point. And Tim, you called out the shipping and the pricing. I certainly understand the pricing. Can you talk about when that anniversaries, like when you put that in and future price increases first? I'll take it in steps.

So, on the shipping side of things, in the latter part of the second quarter, we changed some of our processes around selection of shipping vendor. We automated the process of doing rate shopping to find the lowest cost alternative for customers. But one of our offers to customers who are on our continuity program based on certain order sizes is free shipping. So, approximately two-thirds of the shipping that we send out, we actually absorb the cost of shipping. So saving money on the shipping expense not only passes savings on to some customers, but it's a big savings for us. And I would say that our shipping expense dropped by about 1% of sales in the quarter. For the full quarter -- we had a little bit of a benefit of that in the second quarter, but the full benefit in the third quarter. So, that's the biggest part of it. As you know, we had a price increase earlier in the year in the April time frame. So that always helps a little bit. When we launched the OPTAVIA line in the -- right after convention as well, margins for that product are somewhat similar although pricing is slightly higher. So those are really the things that kind of contributed to margin in the third quarter, which I think you're probably pretty close to being right, Frank. I don't recall margins being much over 76% historically.

One of the reasons for the question is I can totally understand where you're going with the guidance for the revenue for Q4. It does seem like you are expecting, I would think, based on that guidance, a nice -- or a pullback in the gross margin, if I've got that right. And you do typically see a decline I think from Q3 to Q4. Could you just talk about that a little bit?

I think what you're seeing there between Q3 and Q4 is really the preparation for next year, switching over the brand and complete the OPTAVIA. So we launched 13 products earlier this year and as we go into the first half of next year, we'll begin transitioning the rest of the product line over to the OPTAVIA brand. So, there's costs absorbed in the fourth quarter associated with trial costs for all of the new products. Every product goes through testing and trialing, and so you have a pretty good density of those products hitting in the fourth quarter. And those costs kind of hit margin. I think the other things in the fourth quarter, kind of positive things, investments in the future, but we are getting ready to launch a new system in Medifast Direct, as we've mentioned before. The implementation occurs in the fourth quarter. There is a buildup of consulting expense. And as we mentioned, it's a cloud-based software, so not much of that is able to be capitalized, so that's going to flow through in the fourth quarter as well. And you know, on a year-over-year basis --.

Through G&A I take it?

That goes through SG&A, yes.

I guess my last question, just going back to Take Shape for Life, is there anything to point out -- I don't know that I want you to give guidance like for next year, but is there anything to point out in sort of the cadence of how you grow, how you typically grow health coaches? Like because you typically, like, you do fall off in Q4 even when you are growing, right, like a Q3 to Q4. I mean all direct sellers seem to have that issue around the holidays in the US. I mean I assume that would be the same here. But next year, is there anything that might just change that because of the OPTAVIA launch that we should be aware of when we do our quarterly build up?

Frank, this is Dan. We are putting together some programs that will leverage the news. I think a lot of times, I think one of the most powerful things we have in our channel is an anticipation of what's coming. So our teams are working very hard with the field to make the launch of OPTAVIA an important part of our first half. Specifically, we have some product launches that have been, that will be happening starting in February and then leading up to our Dallas convention. And generally, I think you see a lot of field excitement and engagement and belief in the future of this new brand that we are offering exclusively to our health coaches.

Okay. And my last question if I could, on the Direct side, Direct declined, but, at the same time, you pulled back on sales and marketing. Actually, the decline wasn't as bad as I would have actually thought. Do you think that's suggesting maybe a stabilization in that channel?

I think you're going to start to see that, Frank. There's a number of things. We mentioned during the call that the change in the brand not only benefits Take Shape for Life, but we also believe it will benefit Med Direct as far as independence of having, in essence, their own brand as well. And so I think we're looking at this with improvement in kind of us going to the first half of next year, but, you know, maybe a larger improvement hopefully in the second half of next year as the brands split. So, we've had a larger decline; you are right. The decline tapered a bit and we're doing a number of things that hopefully will continue it on that path. In the fourth quarter, we will launch the new technology which enables us to promote differently and also have an improved customer experience. So I think these things, as they get strung along here, we'll see an improvement in Med Direct.

Our next question comes from Mitch Pinheiro from Wunderlich Securities.

Welcome to the conference call scene, Dan. And so a first question, Dan, for you. It might be a little early to answer this, but I'd love to get your initial read on maybe how do you think you are going to be different than your predecessor, either through style, strategy? Is there any color you can share with us this early in your tenure here?

Sure. I will comment on what my fundamental beliefs are? I think the principles that have worked to create long-term sustainable growth in the past, and I think we've got a lot of things going for us. I mean I think, first, you start with our product. It's highly differentiated. Even in the crowded space of health and wellness companies, we have a unique approach with our health coaches and some of these micro habits of health that we drive into the system and our products, the fuelings we call them, and the program. So a big part of it is going to be leveraging those through both creating an easy-to-share story and an easy way to demonstrate the efficacy of our products among our network. It sounds simple and basic, and it is, but the more effective we are at doing that, basically the more quickly and effectively our network will grow. I think the third thing is the fuel engagement strategy, which is a big focus that we are working on right now with the team, which is basically giving our community of health coaches a very simple way to teach and train around a system to bring in new clients, but also transitioning those clients from client to health coach, from health coach to business coach, and from business coach to leader. So a lot of different things we can do to influence that and to help that happen. And I think the biggest thing that we'll be leveraging from, that we haven't had in the past is what the team has prepared with the launch of OPTAVIA. So, we believe giving our Take Shape for Life community exclusive access to this new line of products that, their fuelings, that fit within, with all of our programs is going to be a big boost to what they can do and how we kind of move forward in the future.

Okay, thanks for that. And talking, staying on the OPTAVIA topic, transitioning from one brand to another is not easy, and there might be hiccups along the way. What kind of hiccups should we expect? They might even be minor, but how do you handle inventory transition? How do you handle demand planning? How are you going to handle, you know, just that handoff? I know you started slowly here, which seems an appropriate, you know, sort of soft launch, but what are the things that could come back and bite us, if there are any?

Let me take the first part of the question and then I'll let Tim answer the question on inventory transition. As you know, this project started over two years ago, and it started by working very closely in collaboration with our leaders throughout our business coach community, and talk to them about what we could do with it and how we would make the transition. I think the biggest, I think the thing that we have going for us that makes the transition easier for them is that we haven't changed the fundamental approach to how they do business. In other words, they have a completely new brand and some, a lot of new plans and exciting things to talk about in the form of Clean Label. There are some new ingredients that work, that make the product even more effective than previous. But I think, fundamentally, that the plan and the program that they've been teaching with Medifast brand remains unchanged. So there's not a lot of retraining. Typically, that would be the big friction that you'd add to the system, is that everyone would have to retrain and figure out a new way of doing business. And because of the way the products were developed and because of the way they are supported, it really just becomes more for them to talk about, making the story richer and more exclusive to them. So, we don't see, because of the way we are collaborating, any -- we don't anticipate any big challenges on the implementation side with the network. Tim, do you want to talk about those?

Yes. We've had a good runway here I think to plan, so working with our product development teams and our field leaders. We have a transition to products that takes about a year starting with the prior July when we launched the first 13 products. And then we'll start to sequence in the remainder of the products over in the next eight months or so. So, you'll see a buildup of inventory. You see a little bit already occurring. So our inventory balanced up to about $15 million, up a couple of million dollars this quarter. And I would expect to see that grow a little bit more into the fourth quarter as we change the brands. We'll be carrying both brands for a period of time and then we'll start to work down the inventory. So, you will see it. You will definitely see an uplift in inventory in the fourth quarter, and you'll start to see that go back down again by the end of the first quarter and into second quarter of next year. But we have a very well laid out plan. The products are developed already. Truthfully, a lot of it, at this point, is trials, packaging, all of the finishing work. We are pretty far along.

The other thing, Frank, here, with the 13 non-GMO products, we can attract for the first time people that wouldn't come into our network before because some people have that orientation that they just want non-GMO. And obviously, we know there's nothing wrong with GMO. That's still a huge portion of the business, but that's a very attractive feature for us to bring in people who would not have joined, and our health coaches are saying that. They are attracting people that said no a year ago.

What about the people that want the old Take Shape for Life program? At some point, they are just not going to be over to get that product, or it will be like, listen, you're going to have to transition here, or what happens there?

Effectively, we are creating almost a mirror image of the current flavor makeup of the current -- the Medifast branded products. So, the difference will be that once they go on to the OPTAVIA brand, they will be made with a completely natural flavor profile and free of all the things that are really important, this segment of people that Mike was just referring to. Also --.

And then [Multiple Speakers] I'm sorry.

And then I mentioned as well, I alluded to it earlier, there are some unique ingredients, specifically a probiotic that we are adding. So, we are giving them a reason to like the products because we are transitioning the flavors over to the new lines but also we are giving them a reason to buy in the new line because of some increased claims related to ingredients that we are adding and the absence of some of the artificial sweeteners and flavors we had previously.

Switching to all-natural and adding all these other nutritional benefits, it would seem -- I would seem to think your costs are higher, so this is going to be maybe a slightly premium price to maintain your margins. Is that accurate?

That is accurate. So, the 13 products that we launched the last convention are priced higher than the core Medifast branded products.

And then what percentage of OPTAVIA will be self-manufactured, and how does that compare to the percentage you self-manufacture currently in your core business?

Well, that obviously would be dictated by our customers, but we currently manufacture a little over 40% of our products today. And so far, with the introduction of the OPTAVIA line so far, the percentage we manufacture has actually gone up slightly, a few points.

This concludes our question-and-answer session. I would like to turn the conference back to Dan Chard for closing remarks.

Thank you, everyone, for your questions and participation on today's call. We look forward to speaking with you again when we report our fourth quarter and full year 2016 financial results. Have a great evening.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.