MEDIFAST INC - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2017

OR

For the transition period from                       to                      .

Commission File Number: 001-31573

Medifast, Inc.

(Exact name of registrant as specified in its charter)

100 International Drive
Baltimore, Maryland 21202
Telephone Number: (410) 581-8042

(Address of Principal Executive Offices, Zip Code and Telephone Number, Including Area Code)

3600 Crondall Lane

Owings Mills, Maryland 21117

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Emerging growth company o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

The number of shares of the registrant’s common stock outstanding at November 1, 2017 was 11,933,645.

Medifast, Inc. and subsidiaries

Index

MEDIFAST, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(in thousands, except par value)

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDIFAST, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(in thousands, except per share amounts & dividend data)

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDIFAST, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDIFAST, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED)

(in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDIFAST, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDIFAST, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

General

Basis of Presentation -- The accompanying unaudited condensed consolidated financial statements of Medifast, Inc. and its wholly-owned subsidiaries (the “Company,” “we,” “us,” or “our”) included herein have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”), for interim information and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for reporting on Form 10-Q. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. However, in the opinion of management, all adjustments consisting of normal, recurring adjustments considered necessary for a fair presentation of the financial position and results of operations have been included and management believes the disclosures that are made are adequate to make the information presented not misleading. The condensed consolidated balance sheet at December 31, 2016 has been derived from the audited consolidated financial statements at that date.

The results of operations for the three and nine months ended September 30, 2017 are not necessarily indicative of results that may be expected for the fiscal year ending December 31, 2017. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the 2016 audited consolidated financial statements and notes thereto, which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016 (“2016 Form 10-K”).

Presentation of Financial Statements -- The unaudited condensed consolidated financial statements included herein include the accounts of the Medifast, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Use of Estimates – The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

Revenue Recognition - Revenue is recognized net of discounts, rebates, promotional adjustments, price adjustments, and estimated returns and upon transfer of title and risk to the customer which occurs at shipping (F.O.B. terms). Upon shipment, the Company has no further performance obligations and collection is reasonably assured as the majority of sales are paid prior to shipping.

Accounting Pronouncements Adopted in 2017 --

ASU 2016-09 Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which changes the accounting for certain aspects of share-based payments to employees. The new guidance requires, among its other provisions, that excess tax benefits (which represent the excess of actual tax benefits received at the date of vesting or settlement over the benefits recognized over the vesting period or upon issuance of share-based payments) and tax deficiencies (which represent the amount by which actual tax benefits received at the date of vesting or settlement is lower than the benefits recognized over the vesting period or upon issuance of share-based payments) be recorded in the income statement as an increase or decrease in income taxes when the awards vest or are settled. This is in comparison to the prior requirement that these excess tax benefits be recognized in additional paid-in capital and these tax deficiencies be recognized either as an offset to accumulated excess tax benefits, if any, or in the income statement. The new guidance also requires excess tax benefits to be classified along with other income tax cash flows as an operating activity in the statement of cash flows rather than, as previously required, a financing activity. The new standard is effective for public companies for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period. As such, the Company adopted this standard on January 1, 2017.

As a result of this adoption:

Recent Accounting Pronouncements –

We have considered all new accounting pronouncements and have concluded that there are no new pronouncements that may have a material impact on our results of operations, financial condition, or cash flows, based on current information, except for:

ASU 2016-02, Leases (Topic 842) requires the rights and obligations of all leased assets with a term greater than 12 months to be presented on the balance sheet. The pronouncement is effective for fiscal years beginning after December 15, 2018. Management is currently evaluating the effect that the provisions of ASU 2016-02 will have on the Company’s financial statements.

ASU 2016-01, Financial Instruments- Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, most notably requires the changes in fair value of equity investments to be recognized in net income. The pronouncement also requires the use of the exit price notion, the separate presentation of financial assets and liabilities by measurement category and form of asset, and the separate presentation in other comprehensive income of changes in fair value resulting from a change in the instrument-specific credit risk. The pronouncement is effective for fiscal years beginning after December 15, 2017. Based on the risk level of the Company’s investment portfolio, Management does not expect the pronouncement to have a material impact on the Company’s financial statements.

ASU 2015-09, Revenue from Contracts with Customers (Topic 606), requires the Company to recognize revenue for the transfer of goods or services to customers for the amount the Company expects to be entitled to receive in exchange for those goods or services. The Company will be required to identify the contract, identify the relevant performance obligations, determine the transaction price, allocate the transaction price to the performance obligations in the contract, and recognize the revenue when the entity satisfies a performance obligation. The new revenue standard is effective for annual reporting periods (including interim reporting periods within those periods) beginning January 1, 2018. Companies have the option of using either a full retrospective or a modified retrospective approach to adopt the guidance. The Company intends to adopt the new standard on a modified retrospective basis. The Company is in the process of assessing and implementing the new revenue standard, and has prepared its preliminary accounting policy memorandum and is entering the final stages of its documentation related to the new standard. The Company’s preliminary assessment indicates that the timing of revenue recognition for product shipments with free on board shipping point terms could be impacted. While the Company is currently finalizing its assessment of all of the potential impacts of the new standard, the Company does not expect the implementation of the standard will have a material effect on the Company's consolidated results of operations, cash flows or financial position. The new standard will however require more extensive revenue-related disclosures.

2. FINANCIAL INSTRUMENTS

Certain financial assets and liabilities are accounted for at fair value, which is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The following fair value hierarchy prioritizes the inputs used to measure fair value:

Level 1 – Quoted prices are available in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

Level 2 – Pricing inputs are other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies.

Level 3 – Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management’s best estimate of fair value from the perspective of a market participant.

The following tables represent cash and the available-for-sale securities adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or investment securities (in thousands):

The Company had a realized loss of $16 thousand and a realized gain of $84 thousand for the three months ended September 30, 2017 and 2016, respectively, and a realized loss of $73 thousand and a realized gain of $69 thousand for the nine months ended September 30, 2017 and 2016, respectively. As of September 30, 2017 and 2016, gross unrealized losses related to individual securities that had been in a continuous loss position for 12 months or longer were not significant. The maturities of the Company’s investment securities generally range up to 5 years for municipal bonds and for government and agency securities.

3. INVENTORIES

Inventories consist principally of packaged meal replacements held in the Company’s warehouses. Inventory is stated at the lower of cost or market, utilizing the first-in, first-out method. The cost of finished goods includes the cost of raw materials, packaging supplies, direct and indirect labor and other indirect manufacturing costs. On a quarterly basis, management reviews inventory for unsalable or obsolete inventory.

Inventories consisted of the following (in thousands):

4. Equity

Issuance of Additional Common Stock

On May 18, 2017, the stockholders of the Company approved the Medifast, Inc. Amended and Restated 2012 Share Incentive Plan (the “Amended and Restated 2012 Plan”) that increased the number of shares of the Company’s common stock, par value $.001 per share, that may be awarded under the Amended and Restated 2012 Plan by 600,000, to an aggregate of 1,600,000. During the three months ended September 30, 2017, we did not issue any common stock under the Amended and Restated 2012 Plan and the total number of shares available for issuance remains at 1,600,000 at September 30, 2017.

Stock Repurchase Plan

On June 14, 2017, the Company announced that it had established a stock repurchase plan under Rule 10b-18 of the Securities and Exchange Act of 1934, as amended (the “Stock Repurchase Plan”). The Stock Repurchase Plan permits the Company to repurchase up to 850,000 shares of its common stock until June 30, 2018, unless the plan is terminated earlier in accordance with its terms. There is no guarantee as to the exact number of shares of the Company’s common stock, if any, that will be purchased under the Stock Repurchase Plan. As of September 30, 2017, no shares have been repurchased by the Company under the Stock Repurchase Plan.

5. Leases

On September 18, 2017, Medifast announced the relocation of its corporate offices to 100 International Drive Baltimore, Maryland. As part of this move, Medifast incurred an operating lease with future minimum lease payments totaling $8.8 million to be recognized during the period of August 30, 2017 through February 27, 2026.

6. SHARE-BASED COMPENSATION

Stock Options:

The Company has issued non-qualified and incentive stock options to employees and nonemployee directors. The fair value of these options are estimated on the date of grant using the Black-Scholes option pricing model, which requires estimates of the expected term of the option, the risk-free interest rate, the expected volatility of the price of the Company’s common stock, and dividend yield. Options outstanding as of September 30, 2017 generally vest over a period of three years and expire ten years from the date of grant. The exercise price of these options ranges from $24.26 to $44.73. Due to the Company’s lack of option exercise history, the expected term is calculated using the simplified method defined as the midpoint between the vesting period and the contractual term of each option. The risk free interest rate is based on the U.S. Treasury yield curve in effect on the date of grant that most closely corresponds to the expected term of the option. The expected volatility is based on the historical volatility of the Company’s common stock over the period of time equivalent to the expected term for each award. The weighted average input assumptions used were as follows:

The following table is a summary of our stock option activity:

As of September 30, 2017, the weighted-average remaining contractual life was 7.95 years with an aggregate intrinsic value of $3.5 million for outstanding stock options and the weighted-average remaining contractual life was 7.16 years with an aggregate intrinsic value of $1.9 million for exercisable options.

The weighted-average grant date fair value of options granted during the nine months ended September 30, 2017 and 2016 was $13.73 and $7.91, respectively. The unrecognized compensation expense calculated under the fair value method for shares expected to vest as of September 30, 2017 was $517 thousand and is expected to be recognized over a weighted average period of 1.86 years. The Company received $568 thousand and $299 thousand in cash proceeds from the exercise of stock options during the nine months ended September 30, 2017 and 2016, respectively. The total intrinsic value for options exercised during the nine months ended September 30, 2017 and 2016 was $325 thousand and $69 thousand, respectively.

Restricted Stock:

The Company has issued restricted stock to employees and nonemployee directors generally with vesting terms up to five years after the date of grant. The fair value is equal to the market price of the Company’s common stock on the date of grant. Expense for restricted stock is amortized ratably over the vesting period. The following table summarizes our restricted stock activity:

The total fair value of restricted stock awards vested during the nine months ended September 30, 2017 and 2016 was $2.5 million and $1.9 million, respectively.

The total costs of the options and restricted stock awards charged against income during the three months ended September 30, 2017 and 2016 was $912 thousand and $678 thousand, respectively, and $2.6 million and $1.9 million during the nine months ended September 30, 2017 and 2016, respectively. Also included for the three and nine months ended September 30, 2017 was $291 thousand and $810 thousand in expense for 323,925 shares that will vest based on certain market and performance conditions. Included in share-based compensation for the three and nine months ended September 30, 2016 is $248 thousand and $613 thousand for 59,375 shares of performance awards issuable to certain key employees that will vest on December 31, 2017 based on achieving the 2016 financial plan.

The total income tax benefit recognized in the condensed consolidated statements of income for restricted stock awards was $451 thousand and $315 thousand for the three months ended September 30, 2017 and 2016, respectively, and $1.5 million and $839 thousand for the nine months ended September 30, 2017 and 2016, respectively. The total tax benefit recognized in additional paid-in capital upon vesting of restricted stock awards and exercise of stock options for the nine months ended September 30, 2016 was $105 thousand.

There was $3.0 million of total unrecognized compensation cost related to restricted stock awards as of September 30, 2017, which is expected to be recognized over a weighted-average period of 1.59 years. There was $2.6 million of unrecognized compensation cost related to the 323,925 market and performance award shares discussed above as of September 30, 2017, which is expected to be recognized over a weighted-average period of 2.25 years.

7. BUSINESS SEGMENTS

Operating segments are components of an enterprise for which separate financial information is available that is regularly reviewed by the chief operating decision maker in determining how to allocate resources and in assessing performance. The consolidated operating profit of the Company is reviewed by the chief operating decision maker as a single segment and sales are reviewed at the business unit level. In July 2017, the Take Shape For Life® business was rebranded to OPTAVIA^® (“Optavia”).

The following table presents sales by business segment (in thousands):

8. EARNING PER SHARE

Basic earnings per share (“EPS”) computations are calculated utilizing the weighted average number of shares of common stock outstanding during the periods presented. Diluted EPS is calculated utilizing the weighted average number of shares of common stock outstanding adjusted for the effect of dilutive common stock equivalents.

The following table sets forth the computation of basic and diluted EPS (in thousands, except per share data):

The calculation of diluted earnings per share excluded 3,813 and 10,000 antidilutive options outstanding for the three months ended September 30, 2017 and 2016, respectively, and 6,780 and 87,500 antidilutive options outstanding for the nine months ended September 30, 2017 and 2016, respectively. EPS is computed independently for each of the quarters presented; accordingly, the sum of the quarterly earnings per common share may not equal the year-to-date total computed.

9. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table sets forth the components of accumulated other comprehensive income (loss), net of tax where applicable (in thousands):

Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Note Regarding Forward-Looking Statements

This report contains information that may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” and similar expressions, which are not historical in nature, identify forward-looking statements. However, the absence of these words or expressions does not necessarily mean that a statement is not forward-looking. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future, including statements relating to future operating results, are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016 (the “2016 Annual Report”), and those described from time to time in our future reports filed with the Securities and Exchange Commission.

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and related notes appearing elsewhere herein.

Overview

Medifast, Inc. (together with its consolidated subsidiaries, “we,” “us,” “our,” the “Company,” or “Medifast”) is a leading manufacturer and distributor of clinically proven healthy living products and programs. We produce, distribute and sell weight loss, weight management, and healthy living products, and other consumable health and nutritional products. The Company’s product lines include weight loss, weight management, and healthy living meal replacements, snacks, hydration products, and vitamins. Our product sales accounted for 97% of our revenues for the nine months ended September 30, 2017 and 2016, respectively. In July 2017, the Take Shape For Life® business was rebranded OPTAVIA^® (“Optavia”) which stands for optimal health and wellbeing. The brand transition included the launch of over 20 OPTAVIA^® Essential Fuelings (“Fuelings”) and OPTAVIA^® snacks. Health coaches in the Optavia business unit (“Optavia Coaches”) and clients can choose from more than 60 delicious, convenient, interchangeable, scientifically-designed Fuelings.

The Company’s business units are Optavia, Medifast Direct, Franchise Medifast Weight Control Centers (“MWCC”) and Medifast Wholesale. For the three months ended September 30, 2017, total revenue was $77.2 million as compared to $68.6 million for the three months ended September 30, 2016, an increase of $8.6 million, or 12.6%. For the nine months ended September 30, 2017, total revenue was $223.6 million as compared to $212.1 million for the nine months ended September 30, 2016, an increase of $11.5 million, or 5.4%. The increase for both the three and nine months ended September 30, 2017 resulted primarily from an increase in revenue in the Optavia business unit resulting from an increase in volume and an improved mix as clients switch to higher price products offset by a decrease in revenues in the remaining business units. These revenue changes are further described in the “Overview of Results of Operations” section.

For the nine months ended September 30, 2017, the percentage of total revenue by each business unit was as follows:

See Note 7, “Business Segments” of the notes to the condensed consolidated financial statements for a breakout of revenues of the Company’s business segments for the three months ended September 30, 2017 and 2016 and the nine months ended September 30, 2017 and 2016.

We review and analyze a number of key operating and financial metrics to manage our business, including revenue to advertising spend, number of active Optavia Coaches, and average quarterly revenue generated per Optavia Coach.

Distribution Business Units

Optavia – Optavia is the personal coaching division of Medifast. This coaching network consists of Optavia Coaches, who are independent contractors and trained to provide coaching and support to clients utilizing the Optavia platform. The role of the Optavia Coach is to provide support and personal encouragement to help clients effectively reach and sustain a healthy weight, and adopt habits for a lifetime of health. Within our Trilogy of Optimal Health, the Company offers individuals an opportunity to create sustainable health in all areas of their lives - building a healthy body, developing a healthy mind, and generating healthy finances. In addition to the encouragement and support of our Optavia Coaches, clients of Optavia are offered online product and program information, tools and support, and access to our registered dieticians. Clients of our Optavia Coaches order our products through either the Company’s website, their Optavia Coach’s replicated website or our in-house call center. In addition to the full line of Medifast branded products and programs, Optavia also offers an exclusive product line under the lifestyle brand OPTAVIA^®. Our Optavia Coaches provide coaching and support to their clients throughout the weight-loss and weight-maintenance process. Most new Optavia Coaches are introduced to the opportunity by an existing Optavia Coach. The vast majority of new Optavia Coaches started as weight-loss clients of an Optavia Coach, had success on the Optavia program, and became an Optavia Coach to help others through the weight-loss process.

Optavia is a member of the Direct Selling Association (the “DSA”), a national trade association representing over 200 direct selling companies doing business in the United States. To become a member of the DSA, Optavia, like other active DSA member companies, underwent a comprehensive and rigorous one-year company review by DSA that included a detailed analysis of its company business-plan materials. This review is designed to ensure that a company’s business practices do not contravene DSA’s Code of Ethics. In addition to its DSA membership, Optavia is also a voluntary DSA Code of Ethics participant, which sets higher standards for ensuring compliance. Compliance with the Code of Ethics is paramount to becoming and remaining a member in good standing of the DSA. Accordingly, we believe membership in the DSA by Optavia demonstrates its commitment to the highest standards of ethics and a pledge not to engage in any deceptive, unlawful, or unethical business practices, such as pyramid and other similar schemes. Moreover, Optavia, like other DSA member companies in good standing, has pledged to provide consumers with accurate and truthful information regarding the price, grade, quality, and performance of the products Optavia markets.

Medifast Direct – Through Medifast Direct, our direct-to-consumer business unit, customers order Medifast products directly through the Company’s website, www.medifastnow.com or our in-house call center. This business is driven by a multi-media customer acquisition and retention strategy that includes digital advertising, direct mail, email, public relations, word of mouth referrals, social media initiatives, and other means as deemed appropriate. Medifast Direct provides support through its social communities, in-house call center, and nutrition support team of registered dietitians to better serve its customers.

Franchise Medifast Weight Control Centers – The MWCC business unit sells product through franchise and reseller locations. These locations offer structured programs and a team of professionals to help customers achieve weight-loss and weight-management success at center locations. Counselors at each location work with members to provide nutritional and behavioral support based on the member’s personal needs. As of September 30, 2017, MWCC had 35 franchised centers located in Arizona, California, Louisiana, Minnesota, Maryland, and Wisconsin and two reseller locations in Maryland and Pennsylvania as compared to a total of 55 centers and one authorized reseller location in Pennsylvania as of September 30, 2016.

In 2016, Medifast entered into distribution and licensing agreements with 19 weight control centers previously operating as franchise locations. Under the terms of these agreements, the locations have been rebranded and offer products and services in addition to those available at a MWCC. These additional products complement the Medifast products and plans, which are still utilized as the exclusive weight management program at these locations. These resellers may use Medifast’s trademarks in their marketing and advertising efforts and continue to purchase Medifast-branded products at wholesale directly from the Company.

Medifast Wholesale – Medifast medical providers carry an inventory of wholesale products and resell them to patients while providing appropriate support to help ensure healthy weight loss and weight management.

The Company offers resources to assist the medical providers, their staff and their patients in achieving success with their Medifast program. These medical providers have access to our nutrition support team, marketing assets and training modules to help grow their program and enable patients to achieve their weight loss and associated health goals. Medifast’s nutrition support team includes registered dietitians and a behavioral specialist who provide program support and advice via phone and email.

In 2012, the Company entered into a strategic partnership agreement with Medix, a leader in pharmaceutical obesity products in Mexico. The agreement, which was amended in 2013, granted Medix an exclusive license to distribute Medifast products and programs through physicians and weight control centers in Mexico, Central America and South America under the Medifast brand. During the first quarter of 2017, the Company terminated the licensing agreement with Medix. The termination of the contract allows the Company to refocus on our core businesses. During the second quarter of 2017, Medix closed its center locations.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”). Our significant accounting policies are described in Note 2 of the consolidated financial statements included in the 2016 Annual Report. Other than the accounting change for ASU 2016-09 Compensation — Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, we did not make any other material changes to our critical accounting policies during the nine months ended September 30, 2017.

The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Management develops, and changes periodically, these estimates and assumptions based on historical experience and on various other factors that it believes to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The accounting estimates we consider critical include revenue recognition, impairment of fixed assets and intangible assets, income taxes, reserves for returns, operating leases and clinic closure costs.

Overview of Results of Operations

The following tables reflect our income statements (in thousands, except percentages):

Revenue: Revenue increased $8.6 million, or 12.6%, to $77.2 million for the three months ended September 30, 2017 from $68.6 million for the three months ended September 30, 2016. The revenue to total advertising spend for the three months ended September 30, 2017 was 46.1-to-1 as compared to 37.2-to-1 for the corresponding period in 2016. Total advertising spend, inclusive of broker fees, was $1.7 million for the three months ended September 30, 2017 as compared to $1.8 million for the corresponding period in 2016. Revenue increased $11.5 million, or 5.4%, to $223.6 million for the nine months ended September 30, 2017 from $212.1 million for the nine months ended September 30, 2016. The revenue to total advertising spend for the nine months ended September 30, 2017 was 36.7-to-1 as compared to 27.9-to-1 for the corresponding period in 2016. Total advertising spend, inclusive of broker fees, was $6.1 million for the nine months ended September 30, 2017 as compared to $7.6 million for the corresponding period in 2016.

For the three months ended September 30, 2017, Optavia revenue was $66.4 million as compared to $56.5 million for the corresponding period in 2016. This is the eighth consecutive quarter-over-quarter of revenue growth for Optavia. The number of active earning Optavia Coaches for the three months ended September 30, 2017 increased to 14,200 from 12,800 for the corresponding period in 2016, an increase of 10.9%. The quarterly revenue per Optavia Coach increased 6.2% to $4,693 for the three months ended September 30, 2017 from $4,421 for the three months ended September 30, 2016. Optavia revenue increased $17.3 million, or 10.1%, to $187.9 million for the nine months ended September 30, 2017 from $170.6 million for the nine months ended September 30, 2016 as a result of an increase in volume, an improved mix as clients switch to higher priced products and the price increase that was effective April 2016.

Medifast Direct revenue decreased $0.3 million, or 3.7%, to $7.8 million for the three months ended September 30, 2017 from $8.1 million for the three months ended September 30, 2016. This is the second quarter in a row that the Medifast Direct revenue quarterly decrease has been in the single digits. Sales for the quarter were down in comparison to the corresponding quarter in 2016 as new customer acquisition continued to be challenging. Revenues in this business unit are driven primarily by targeted customer marketing and advertising as well as the direct response initiatives we have in place. Medifast Direct advertising during the three months ended September 30, 2017 decreased $0.1 million, or 5.9%, to $1.6 million from $1.7 million for the three months ended September 30, 2016. The Company continues to reduce advertising spending and only invests in initiatives that meet distinct criteria in an effort to focus on determining the ideal media mix to optimize profitability. For the nine months ended September 30, 2017, Medifast Direct revenue was $25.3 million as compared to $28.4 million for the corresponding period in 2016.

For the three months ended September 30, 2017, MWCC revenue was $2.8 million as compared to $3.7 million for the corresponding period in 2016. MWCC revenue decreased $2.4 million, or 20.0%, to $9.6 million for the nine months ended September 30, 2017 from $12.0 million for the nine months ended September 30, 2016. The decrease in revenue for both the three and nine months ended September 30, 2017 was primarily driven by fewer franchise centers in operation during these periods combined with a decline in activity within the centers and a decrease in resellers. As of September 30, 2017, the Company had 35 franchise centers and two reseller locations in operation as compared to 55 franchise centers and one authorized reseller location at the end of the same period last year.

Medifast Wholesale revenue decreased $51 thousand, or 18.7%, to $222 thousand for the three months ended September 30, 2017 from $273 thousand for the three months ended September 30, 2016. For the nine months ended September 30, 2017, Medifast Wholesale revenue was $713 thousand as compared to $1.1 million for the corresponding period in 2016. The decrease for the quarter and year-to-date were due to the loss of certain accounts resulting from Medifast’s enforcement of business partner compliance distribution requirements.

Costs of Sales: Cost of sales increased $2.6 million, or 15.9%, to $19.0 million for the three months ended September 30, 2017 from the corresponding period in 2016 and increased $1.4 million, or 2.6%, to $54.9 million for the nine months ended September 30, 2017 from the corresponding period in 2016. The increase in cost of sales for the three and nine months ended September 30, 2017 was primarily driven by higher sales and an increase in manufacturing costs as the Company is no longer building inventory for the Optavia launch.

Gross Profit: For the three months ended September 30, 2017, gross profit increased $6.0 million, or 11.5%, to $58.2 million from the corresponding period in 2016. As a percentage of sales, gross margin decreased 70 basis points to 75.4% for the three months ended September 30, 2017 from 76.1% for the corresponding period in 2016. The gross margin percentage decline for the quarter primarily resulted from the increased costs of sales due to increased manufacturing costs as the Company is no longer building inventory for the Optavia launch. For the nine months ended September 30, 2017, gross profit increased $10.1 million, or 6.4%, to $168.7 million from the corresponding period in 2016. As a percentage of sales, gross margin increased 70 basis points to 75.5% for the nine months ended September 30, 2017 from 74.8% for the corresponding period in 2016. The gross margin percentage improvement for the year-to-date period was primarily driven by an increase in revenue from an improved mix as clients switch to higher price products and the price increase effective April 2016.

Selling, General and Administrative: Selling, general and administrative (“SG&A”) expenses were $48.0 million for the three months ended September 30, 2017, an increase of $4.8 million, or 11.0%, as compared to $43.2 million for the corresponding period in 2016. This increase was primarily the result of increased Optavia commissions resulting from increased related sales. SG&A expenses included research and development costs of $343 thousand and $311 thousand for the three months ended September 30, 2017 and 2016, respectively. As a percentage of sales, SG&A expenses were 62.1% for the three months ended September 30, 2017 as compared to 63.0% for the corresponding period in 2016.

For the nine months ended September 30, 2017, SG&A expenses increased $0.2 million, or 0.1%, to $138.5 million from $138.3 million for the corresponding period in 2016. This increase was primarily the result of increased Optavia commissions, salaries and related benefits partially offset by the $6.1 million in impairment costs and $1.2 million in restructuring cost incurred during the nine months ended September 30, 2016. Excluding the impairment and restructuring costs, adjusted SG&A expenses increased $7.4 million to $138.5 million for the nine months ended September 30, 2017 from $131.1 for the corresponding period in 2016. SG&A expenses included research and development costs of $1.1 million and $1.5 million for the nine months ended September 30, 2017 and 2016, respectively. As a percentage of sales, SG&A expenses were 62.0% for the nine months ended September 30, 2017 as compared to 65.2% for the corresponding period in 2016.

Optavia commission expense, which is variable based upon product sales and the number of Optavia Coaches, increased $4.1 million, or 17.3%, for the three months ended September 30, 2017 from the corresponding period in 2016, which is in line with the sales growth of 17.5% that Optavia experienced during the period. For the nine months ended September 30, 2017, Optavia commission expense increased $7.4 million, or 10.4%, from the corresponding period in 2016, which is in line with the sales growth of 10.1% that Optavia experienced during the period.

Salaries and benefits increased $1.1 million quarter-over-quarter for the three months ended September 30, 2017, primarily as a result of higher incentive costs and share-based compensation expense. For the nine months ended September 30, 2017, salaries and benefits increased $1.8 million from the corresponding period in 2016 primarily as a result of higher incentive costs, share-based compensation expense, and salaries and related benefits offset by a onetime severance expense that was incurred during the nine months ended September 30, 2016.

Sales and marketing expenses decreased $119 thousand during the three months ended September 30, 2017 and decreased $1.1 million during the nine months ended September 30, 2017 from the corresponding periods in 2016. This decrease for the nine months ended September 30, 2017 was primarily driven by reduced advertising spend, particularly for Medifast Direct.

General and administrative expenses decreased $317 thousand for the three months ended September 30, 2017 and decreased $7.9 million for the nine months ended September 30, 2017 from the corresponding periods in 2016. The decrease for the nine months ended September 30, 2017 was primarily due to the impairment costs incurred during the nine months ended September 30, 2016.

Income from operations: For the three months ended September 30, 2017, income from operations increased $1.2 million to $10.2 million from $9.0 million for the corresponding period in 2016 primarily as a result of increased gross profits partially offset by increased SG&A expenses. Income from operations for the nine months ended September 30, 2017 increased $9.9 million to $30.1 million from $20.2 million for the corresponding period in 2016 primarily as a result of increased revenue. Adjusted income from operations which excludes impairment costs and restructuring costs recorded in 2016 increased $2.7 million to $30.1 million for the nine months ended September 30, 2017 from the corresponding period in 2016.

Interest income, net: For the three months ended September 30, 2017 and 2016, interest income was $148 thousand and $60 thousand, respectively, and for the nine months ended September 30, 2017 and 2016, interest income was $352 thousand and $240 thousand, respectively.

Other income (expense): For the three months ended September 30, 2017 and 2016, other expense was $4 thousand and $2 thousand, respectively. For the nine months ended September 30, 2017 and 2016, other income was $32 thousand and other expense was $23 thousand, respectively.

Income from operations before income taxes: Income from operations before income taxes was $10.4 million for the three months ended September 30, 2017 as compared to $9.0 million for the three months ended September 30, 2016, an increase of $1.4 million. Pre-tax profit as a percentage of sales increased to 13.4% for the three months ended September 30, 2017 from 13.1% for the three months ended September 30, 2016. Income from operations before income taxes was $30.5 million for the nine months ended September 30, 2017 as compared to $20.5 million for the nine months ended September 30, 2016, an increase of $10.0 million. Pre-tax profit as a percentage of sales increased to 13.7% for the nine months ended September 30, 2017 from 9.6% for the nine months ended September 30, 2016.

Provision for income tax expense: For the three months ended September 30, 2017, the Company recorded $3.7 million in income tax expense, an effective rate of 35.5%, as compared to $2.9 million in income tax expense, an effective rate of 32.7%, for the three months ended September 30, 2016. The increase in the effective tax rate for the three months ended September 30, 2017 as compared to the three months ended September 30, 2016 was primarily driven by an increase in state income taxes. For the nine months ended September 30, 2017, the Company recorded $10.1 million in income tax expense, an effective rate of 33.1%, as compared to $6.7 million in income tax expense, an effective rate of 32.9%, for the nine months ended September 30, 2016. The increase in the effective tax rate for the nine months ended September 30, 2017 as compared to the nine months ended September 30, 2016 was primarily due to the 1.2% rate reduction related to the discrete change in accounting for taxes associated with share-based compensation, 0.3% rate increase of the state income tax and by a 1.0% reduction to the benefit from the Domestic Manufacturer Deduction. The Company anticipates a full year tax rate of 33% to 34% in 2017.

Net income: Net income was $6.7 million and $20.4 million, or $.55 and $1.69 per diluted share, for the three and nine months ended September 30, 2017 as compared to $6.1 million and $13.7 million, or $.51 and $1.15 per diluted share, for the three and nine months ended September 30, 2016, respectively. Excluding restructuring and impairment costs, adjusted net income was $18.6 million, or $1.56 per diluted share for the nine months ended September 30, 2016. The period-over-period changes were driven by the factors described above in the explanations from operations.

Non-GAAP Financial Measures

In an effort to provide investors with additional information regarding our results as determined by GAAP, we disclose various non-GAAP financial measures in our quarterly earnings press release and other public disclosures. The following GAAP financial measures have been presented on an as adjusted basis: SG&A expenses, income from operations, net income and diluted earnings per share. Each of these as adjusted financial measures excludes the impact of certain amounts as further identified below and have not been calculated in accordance with GAAP. A reconciliation of each of these non-GAAP financial measures to its most comparable GAAP financial measure is included below. These non-GAAP financial measures are not intended to replace GAAP financial measures.

We use these non-GAAP financial measures internally to evaluate and manage the Company’s operations because we believe they provide useful supplemental information regarding the Company’s on-going economic performance. We have chosen to provide this information to investors to enable them to perform more meaningful comparisons of operating results and as a means to emphasize the results of on-going operations.

The following tables reconcile the non-GAAP financial measures included in this report (in thousands):

(1) The weighted-average diluted shares outstanding used in the calculation of these non-GAAP financial measures are the same as the weighted-average shares outstanding used in the calculation of the reported per share amounts.

Liquidity and Capital Resources

The Company had stockholders’ equity of $108.2 million and working capital of $89.1 million at September 30, 2017 as compared with $96.0 million and $76.9 million at December 31, 2016, respectively. The $12.2 million net increase in stockholder’s equity reflects $20.4 million in net income for the nine months ended September 30, 2017 offset by $11.6 million declared dividends to stockholders as well as other equity transactions as described in the “Condensed Consolidated Statements of Changes in Stockholders’ Equity” included in our condensed consolidated financial statements. The Company declared a dividend of $4.1 million, or $0.32 per share, to common stockholders as of September 22, 2017 that will be paid in the fourth quarter of 2017. While we intend to continue the dividend program and believe we will have sufficient liquidity to do so, we can provide no assurance we will be able to continue the declaration and payment of dividends. The Company’s cash, cash equivalents, and investment securities increased from $76.8 million at December 31, 2016 to $95.7 million at September 30, 2017.

Net cash provided by continuing operating activities increased $7.2 million to $33.3 million for nine months ended September 30, 2017 from $26.1 million for the nine months ended September 30, 2016 primarily as a result of increased net income and an increase in cash generated from working capital.

Net cash used in discontinued operating activities was $471 thousand for the nine months ended September 30, 2016.

Net cash used in investing activities was $3.4 million for the nine months ended September 30, 2017 as compared to $1.2 million for the nine months ended September 30, 2016. This change resulted primarily from cash used in net investment securities for the nine months ended September 30, 2017 as compared to cash provided by net investment securities for the corresponding period in 2016. Also, cash generated from the sale of property, plant and equipment decreased and cash used in capital expenditures increased for the nine months ended September 30, 2017 from the corresponding period in 2016.

Net cash used in financing activities increased $2.4 million to $11.8 million for nine months ended September 30, 2017 from $9.4 million for the nine months ended September 30, 2016. This increase was primarily due to an increase in cash dividends paid to stockholders.

In pursuing its business strategy, the Company may require additional cash for operating and investing activities. The Company expects future cash requirements, if any, to be funded from operating cash flow and financing activities.

The Company evaluates acquisitions from time to time as presented.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and a decline in the stock market. The Company does not enter into derivatives, foreign exchange transactions or other financial instruments for trading or speculative purposes.

The Company is exposed to market risk related to changes in interest rates and market pricing impacting our investment portfolio. Its current investment policy is to maintain an investment portfolio consisting of municipal bonds, U.S. money market securities, and high-grade corporate securities, directly or through managed funds. Its cash is deposited in and invested through highly rated financial institutions in North America. Its marketable securities are subject to interest rate risk and market pricing risk and will fall in value if market interest rates increase or if market pricing decreases. If market interest rates were to increase and market pricing were to decrease immediately and uniformly by 10% from levels at September 30, 2017, the Company estimates that the fair value of its investment portfolio would decline by an immaterial amount and therefore it would not expect its operating results or cash flows to be affected to any significant degree by the effect of a change in market conditions on our investments.

There have been no material changes to our market risk exposure since December 31, 2016.

Item 4. Controls and Procedures

Management, including our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of September 30, 2017. Our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported accurately and on a timely basis. Based on this evaluation performed in accordance with the criteria established in the 2013 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, our management concluded that the Company’s disclosure controls and procedures are effective of the reasonable assurance level as of the end of the period covered by this report.

Changes in Internal Control over Financial Reporting:

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II Other Information

Item 1. Legal Proceedings

The Company is, from time to time, subject to a variety of litigation and similar proceedings incidental to its business.  Based upon the Company’s experience, current information and applicable law, it does not believe that these proceedings and claims will have a material adverse effect on its results of operations, financial position or liquidity.

Item 1A. Risk Factors

There have been no material changes to the risk factors set forth in Part I, Item 1A of the 2016 Annual Report.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

(1)  200 shares of the Company’s common stock were surrendered by employees to the Company for the payment of the minimum tax liability withholding obligations upon the vesting of shares of restricted stock previously granted to such employees.

(2)  At the outset of the quarter ended September 30, 2017, there were 847,567 shares of the Company's common stock eligible for repurchase under the repurchase authorization dated September 16, 2014.

On June 14, 2017, the Company announced that it had established a stock repurchase plan under Rule 10b-18 of the Securities and Exchange Act of 1934, as amended (the “Stock Repurchase Plan”). The Stock Repurchase Plan permits the Company to repurchase up to 850,000 shares of its common stock until June 30, 2018, unless the plan is terminated earlier in accordance with its terms. There is no guarantee as to the exact number of shares of the Company’s common stock, if any, that will be purchased under the Stock Repurchase Plan. As of September 30, 2017, no shares have been repurchased by the Company under the Stock Repurchase Plan.

Item 6. Exhibits

In accordance with SEC Release No. 33-8238, Exhibit 32.1 is being furnished and not filed.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

Medifast, Inc.

EXHIBIT INDEX

In accordance with SEC Release No. 33-8238, Exhibit 32.1 is being furnished and not filed.