Cheap compounder unduly punished after dividend cutHot take: there's alpha in buying dividend cuts
Here's a contrarian belief I hold: dividend cuts are almost always good, because they extend the life and increase the terminal value of the company.
However, the market almost always punishes companies that cut dividends. There are two reasons for that:
1) A lot of investors don't read financial reports and don't know the financial situation of the company until the dividend cut acts as an information signal.
2) Income/dividend investing tends to be very rules-based, with the main rule being that you should only own "dividend aristocrats" that have steadily increased dividends without a cut.
Thus, there tends to be more sellers than buyers for a while after a dividend cut, because the income investors jump ship faster than the value investors catch on. A dividend cut can therefore present a good buying opportunity for value investors who can time it right.
And there's another factor to consider, too, which is that not every dividend cut is a sign of financial distress. There are two kinds of companies that cut dividends: those that couldn't sustain the payout, and those that see a market opportunity and want to pivot to growth. Uninformed investors often punish both types of dividend cuts identically, even though the meaning of the information signal is quite different in the two cases.
Medifast: an unduly punished compounder
And that brings me to the case of Medifast, a small-cap nutrition and weight-loss company that discontinued its $6.60/share dividend last month. Was this because of financial distress? Actually, no. Medifast had $11.01/share of earnings and $15.57/share of free cash flow over the last 12 months, so it easily could have sustained the dividend. Medifast's explanation for the cut is that it wants to free up capital to pursue a growth strategy. With the recent popularity of GLP-1 weight loss drugs like Ozempic, Medifast wants to add GLP-1s as a core part of its health coaching business and quickly scale the business out. The dividend cut is a sign of distress only in the sense that Medifast earnings and revenue have declined since mid 2022, and the company is moving to arrest that slump and return its trajectory to growth.
How cheap it it really?
Let's look at Medifast's multiples. According to its last financial report, Medifast has zero debt and just $17 million in lease obligations. With a $578 million market cap and $113 million in cash and cash equivalents, that puts Medifast's enterprise value at $482 million.
Over the last twelve months, Medifast generated about $1.2 billion in sales, $119 million in earnings, and $170 million in free cash flow, which gives it the following multiples:
EV/earnings: 4.1
EV/sales: 0.4
EV/FCF: 2.8
That's a 35% trailing twelve months free cash flow yield.
Now, Medifast is definitely more expensive on a price-to-book basis, about 3.0 P/B. But that's not necessarily a bad thing, as it indicates that Medifast is a capital-light business with a high return on invested capital. If it can get anywhere near the same return on its savings from the dividend cut, then there's a lot of growth potential here.
We do have to be a little cautious about the TTM multiples, because Medifast may have been over-earning during this period. But if we use linear-modeled rather than real numbers, the results aren't dramatically different. The EV/earnings and EV/sales multiples change only negligibly, though EV/FCF rises to 4.0 (free cash flow yield of 25%).
To be sure, analysts' forward estimates paint a more subdued picture, with a forward EV/earnings multiple of about 8.9 and forward EV/sales of about 0.6. But those are still good multiples, and it's important to note that Medifast has a long history of crushing analyst estimates. In the last fours quarters, it beat earnings forecasts by 99%, 92%, 53%, and 67%, with revenue beats ranging from about 1% to 10%. So the analysts may be underrating Medifast's prospects here, and I am looking for earnings at least 40% better than forecast.
Even if they fail to monetize GLP-1s, they can buy back stock
Even if I'm wrong, 8.9 and 0.6 are still really good multiples, making this an attractive value stock. And Medifast's dividend cut should free up capital not only for its growth strategy, but also for opportunistic buybacks while the stock is cheap.
Medifast is my largest single name, at about 5% of my portfolio. There is support at the March 2018 low of $50.11 and the March 2020 low of $41.53. I'm looking for a double, to about $107.
