Are you in need for regular income in the face of near-zero interest rates? Have your go-to income investments shriveled up?
You can use options to generate income to replace or enhance your strategy, although you must use them carefully.
Selling naked (or cash-secured) puts against value stocks is the method we like the most.
The reason for this specific strategy is that, should a stock get put to us, we get it at a value price – a price below what we consider to be below long-term intrinsic value.
Not only that, you collect a premium in the process which gives you the income you seek.
This is different from selling naked puts against a random stock that may have temptingly high premiums. You can’t get greedy by selling naked puts against highly volatile momentum stocks.
Stick with value and stick with discipline. Be an investor, not a gambler.
Thesis
The truth of every company pitching weight-loss and weight management plans is that diets do not work. You can swap the names around, give it new nomenclature, dress it up with scientific gobbledegook, but diets are all the same, and they do not work for the long-term.
Every few years a study comes out demonstrating that diets do not work for the long-term. This makes sense logically, because if diets did work over the long-term, then weight loss companies would run out of customers over time.
Instead, Medifast, Inc.(MED) and others wisely moved away from the “diet” word to “weight management” and is now pushing its OPTAVIA “lifestyle solution”, describing it as:
“OPTAVIA is a highly effective lifestyle solution for people for whom diets alone have failed. Habits of Health®, the approach developed by OPTAVIA Co-founder and independent OPTAVIA Coach, Dr. Wayne Scott Andersen, combines clinically proven plans with scientifically developed products and the ongoing support of Coaches. We sell a variety of weight loss, weight management and healthy living products all based on our proprietary formulas…”
Medifast combines the weight management concept with human interaction via coaching. Motivational team members help with weight management. Combine their services with the food that Medifast sells, and then the business is all about marketing and branding.
There is a never-ending supply of customers in the world. People are always trying to manage their weight, and there is no shortage of people doing this around the world. Everyone wants to be healthy and everyone wants to look good. So they go to gyms, exercise, and try weight management for long periods of time.
Health and weight management are an obsession in Western culture and that’s not going to change.Medifast also created the Coach model as a kind of quasi-MLM, although they say it has nothing to do with MLM:
“The Coach model creates a continuous cycle of growth as clients become active earning OPTAVIA Coaches and activate new clients, many of whom also become Coaches. Incentives are designed to support each client and Coach’s long-term success. Coaches learn a simple success system to help candidates become clients. Then Coaches provide their clients with the encouragement and inspiration they need at just the right time. Becoming a Coach can help clients maintain their healthy weight as they become role models for their clients. At the same time, OPTAVIA plays an important role in financial wellness, providing Coaches with the opportunity to improve their finances and change the health trajectory of families, communities and generations.”
You can decide whether it’s MLM or not, but it doesn’t matter. Because Medifast is a solid business that reinvented itself, and has a solid balance sheet with $105 million in cash and no long term debt.
Not only that, we believe the COVID quarantine is going to encourage many people to take the downtime to tackle weight management – while others will surely become couch potatoes.
Medifast’s pivot has resulted in strong net income growth, growing more than fourfold from $18 million in FY16 to $78 million in FY19. It generates solid if not spectacular cash flow because it has very little capex.
Valuation Rules
What do we consider a value stock? Does MED stock qualify?
When it comes to most stocks, we look for a PEG ratio of 1.0 or less, per Peter Lynch.
The growth rate is based on the five-year annualized growth rate as determined by analysts, which is currently 20%. At a price of $87 on Wednesday, MED stock trades at 14x FY19 earnings of $6.29 per share.
That gives MED stock a PEG ratio of only 0.70. Not only is it a value stock now, but selling naked puts means it could be put to us at an ever lower price.
Risks
The biggest risk to MED stock is if its direct sales model gets shut down or restricted by regulators. The FTC came down on Herbalife in recent years, and every few years the hue and cry over MLM companies pressures the FTC into some kind of action. There is risk here, although at present that risk seems minimal.
The Coach model is growing rapidly, increasing from 24,100 Coaches in FY18 to 31,800 in FY19. That growth is phenomenal, but it requires Medifast to keep its infrastructure up to snuff. If internal operations stagger, whether from COVID or anything else, growth could rupture.
Medifast’s food products are made by third parties and supply chain disruptions could seriously harm its business because it is centered around sales of those food products.
Weight management is highly competitive. There is always a battle for market share and the next new thing, and Medifast must stay on top of its marketing and branding to maintain market share. It also must continue to innovate.
Actionable Conclusion
What puts can we sell with MED stock at $87 as of Wednesday’s close?
The June $80 puts are going for about $3.25 each. Earning more than 4% in about 5 weeks is an incredibly generous premium, as it usually is closer to about 2%.
If MED shares are put to you, you will be buying MED stock at the equivalent of $76.75 per share, which is about an 14% discount from even this low price, and you get a $3.76 annual dividend as well, which would mean a yield of almost 4.6%.
For those who want to wait a little bit longer to see how the business environment shakes out, the September $75 puts are going for about $8
If put to you, you will be buying MED stock at the equivalent of $67 per share, a discount of more than 23% from this already cheap price point, and you’ll own MED stock at an impossibly low P/E of 11.
Finally, for the most conservative choice, December $70 puts sell for about $9.10 each.
You first earn 13% on your money, and in the process you’d be hedging your MED stock bet all the way down to $61 per share – near its recent panic low – and owning it at just 10x TTM earnings.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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