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Edited Transcript of MED earnings conference call or presentation 7-Nov-19 9:30pm GMT

Q3 2019 Medifast Inc Earnings Call

OWINGS MILLS Nov 15, 2019 (Thomson StreetEvents) -- Edited Transcript of Medifast Inc earnings conference call or presentation Thursday, November 7, 2019 at 9:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Daniel R. Chard

Medifast, Inc. - CEO & Director

* Katie M. Turner

ICR, LLC - MD

* Timothy G. Robinson

Medifast, Inc. - CFO

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Conference Call Participants

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* Douglas Matthai Lane

Lane Research - Principal & Director of Research

* Linda Ann Bolton-Weiser

D.A. Davidson & Co., Research Division - Senior Research Analyst

* Stephanie Marie Schiller Wissink

Jefferies LLC, Research Division - Equity Analyst and MD

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Presentation

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Operator [1]

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Good afternoon, and welcome to the Medifast Third Quarter Fiscal 2019 Earnings Conference Call.

(Operator Instructions)

Please note, today's event is being recorded. I would now like to turn the conference over to Katie Turner. Please go ahead, ma'am.

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Katie M. Turner, ICR, LLC - MD [2]

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Good afternoon, and welcome to Medifast's Third Quarter 2019 Earnings Conference Call. On the call with me today are Dan Chard, Chief Executive Officer; and Tim Robinson, Chief Financial Officer.

By now, everyone should have access to the earnings release for the period ended September 30, 2019, that went up this afternoon at approximately 4:05 p.m. Eastern Time. If you have not received the release, it's available on the Investor Relations portion of Medifast's website at www.medifastinc.com. This call is being webcast, and a replay will be available on the company's website.

Before we begin, we'd 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 on today's call. All of the forward-looking statements contained herein speak only as of the date of this call.

And with that, I'd like to turn the call over to Medifast's Chief Executive Officer, Dan Chard.

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Daniel R. Chard, Medifast, Inc. - CEO & Director [3]

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Thank you, Katie, and good afternoon to everyone joining us. Thank you, as always, for your interest in Medifast. I'll start today's call by giving you an overview of our third quarter performance, then Tim will review the financial results in more detail and provide our fourth quarter and full year guidance. We'll then both be available to take any questions.

Medifast continues to be resolutely focused on driving long-term sustainable growth for all our stakeholders as we dedicate ourselves to our central mission to offer the world lifelong transformation, one healthy habit at a time. We firmly believe that Medifast revenues can double every 3 to 4 years, and that this growth path can be maintained for a considerable time to come. With our eyes very much on that consistent growth trajectory, we are investing in the development of our organizational capability, our skills and our geographic footprint. We believe this strategic focus will allow us to take advantage of the significant opportunities that lie ahead.

Our coaching model is at the heart of Medifast's competitive difference, with clinical studies demonstrating that people who have a coach alongside them on their weight loss or health transformation journeys achieve and maintain better results than those who do it alone. With that in mind, we're placing a clear focus on building and developing our coaching community, giving them all the vital tools necessary to help us increase the number of people we reach every day with our products and services.

We accelerated our growth in active earning coaches during the quarter, and have exceeded even our own challenging goals. Having set ourselves a target of securing 30,000 coaches by the end of 2019, we significantly outpaced our schedule and surpassed 30,000 coaches in the second quarter of the year. We're now well on course to reach our stated goal of 50,000 active earning coaches by 2021, a milestone, which we believe will play a lead role in our ability to deliver $1 billion in revenue with an operating margin greater than 15% by the same point in time.

We're not just adding new coaches, we're also maintaining a high level of productivity. Average revenue per coach was relatively stable in the period despite the continued increase in coach numbers, demonstrating the success we're having in helping the coach community optimize their individual businesses. Coaches are central to our success. As such, it's vital that we continue to develop our approach to development, networking and field alignment to be certain, we're providing coach leadership in the wider community with an easily repeated scalable process and workflow to drive growth.

Providing opportunities bring leaders together to impart best practices, share intelligence from the field and develop new skills is very important to our mission. Last month, we hosted our latest International Leadership Alignment Summit in Sundance, Utah. This event brings together more than 150 of our key OPTAVIA coach leaders, along with senior executives from Medifast, to share information, train the next-generation of coach leaders and ensure that we listen to and incorporate the feedback of our coach and client community.

Most importantly, we work collaboratively to align behind the shared vision for the future, focusing on our goals for the next 2 years, reviewing and enhancing our product and technology road map and optimizing coach and client support to support our long-term growth projections. The event was also notable for the broadened focus on our international business, with many of our leaders now managing coaches in our first 2 expansion markets, Hong Kong and Singapore.

We're making clear progress in our international business as we support clients and coaches in Hong Kong and Singapore, building our scalable infrastructure to facilitate the growth opportunity we believe exists in the Asia Pacific region.

We're optimizing our product range to create SKUs, developed specifically for these markets, which already show real resonance in our target market. We're also consistently reviewing and enhancing our technology to ensure that our user experience in international markets remain strong. That means developing a new mobile app with client management, ordering and meal planning capabilities as well as making sure that we can add new languages quickly and effectively as we expand.

Growth is key for Medifast, and that requires making changes to legacy systems and processes and ensuring that we are constantly optimizing and reconfiguring in order to have the shape and structure that can enable greater scale. As with many businesses, building an organization for the future can have some adverse impacts in the present, and we've seen some short-term growing pains in Medifast in the last quarter.

We're still driving strong growth, but we've made some adjustments to our financial guidance to reflect the impacts that we've seen. Tim will provide more detail in a moment. But there are 3 key areas which have impacted our results in this quarter. I want to take a few moments to talk about each of those, and the measures we put in place to address them.

First, credit cards. Effectively processing a high-volume of online transactions is a complex issue for all businesses, particularly those operating at the nexus of retail and technology. At Medifast, we experienced some issues in the second and third quarters related to a highly organized automatic scheme using stolen identities and credit cards transact business on our e-commerce sites. Each of these transactions was preapproved prior to shipment by the payment processor and subsequently reported to Medifast as utilizing a stolen card.

We saw significant escalation in this activity in the third quarter, and this led to an unanticipated negative effect on profitability, revenue and forecasting as well as client retention. While this was certainly an issue for Medifast, it caused greater problems for coaches and their ability to manage and forecast client acquisition activity effectively. We've worked hard to establish a dependable and repeatable business rhythm over the past 2.5 years, and this unexpected bump in the road clearly caused some short-term difficulties for coaches.

During the third quarter, we implemented a specialized software and ordering logic system, which has enabled us to neutralize the threat moving forward. This action has helped us bring bad debt back down to levels consistent with historical performance and restore stability to our coach community.

The second area is technology migrations. Medifast may be viewed as a health and wellness company, but the nature of the consumer and the way we interact with coaches and clients means that we are, in many ways, a technology business. Technology, user experience and data are at the very heart of everything we do, and that's certain. And that centrality increases every day.

OPTAVIA has emerged from a business that is nearly 40 years old, and as such, we've had a number of legacy technology systems that we have built on over a period of time. Unwinding those systems and replacing them with new, more rigorous approaches that are capable of handling the skill that we're projecting is a priority, particularly as the number of clients and active earning coaches grows at the same time.

By migrating all of our mission-critical systems, including those impacting business intelligence, commissions, e-commerce and CRM, we'll build a platform that will enable us to scale significantly and expand well beyond our current markets. The technology migrations earlier this year were essential to our growth, and the transition caused residual issues that impacted the quality of the coach and client experience, and that is really the second area that we have seen -- where we have seen an impact on our numbers in the quarter.

Migration is absolutely central to our long-term growth and the temporary effects on experience and retention resulted in a lower-than-expected activity in the third quarter and will have some residual effects on our financial results in the fourth quarter.

By the end of the year, we will have completed a number of technology improvements to address the majority of the problems in user experience, and we anticipate a noticeable positive impact on client retention in the coming months. We have taken active steps to improving client experience with technology, working with some of the best-in-class vendors. To ensure the full focus of this process and to allow the updates to be made in our systems, we've delayed our planned ERP implementation by 3 months, and now expect that to go live in the second quarter of next year.

Finally, supply chain. We've seen rapidly increasing volume demands, which is a great problem to have. To ensure our supply chain could keep pace with the growth in active earning coaches and the increased demands of clients they support, we increased our supply chain capacity by about 40% in the second and third quarters. These changes give us the additional capacity to support the future growth of our business. Changes meant that we need to dismantle and restructure our supply chain operations to allow the new -- for new equipment and systems to come online.

While I'm pleased that this process has taken place, and we're now geared up for future growth, this created some short-term order inaccuracies and disruption in standard operations. These issues led to temporary impacts on client satisfaction and purchasing habits, and we saw some symptoms of that in the quarter, with higher product return requests and higher order concessions to impacted clients. These had an adverse impact on our gross margin in the quarter.

While we'll see some residual effects of these short-term headwinds in the fourth quarter, I'm confident that we've mitigated most of the problems and have an actionable plan in operation to address the outstanding issues.

We've scheduled several compelling promotions in the current quarter to further accelerate client acquisition and reactivation. Typically, the fourth quarter is a slower sales quarter, but we believe these promotions will generate additional field energy and drive performance as we move beyond these short-term growth related impacts.

What remains clear is that the fundamentals of our business are very strong, and we've created a foundation that allows us to build significant revenue growth for the long term. Our management and the board have high confidence in the business, reflected both in the amount of stock bought back in the quarter and by the additional stock repurchase authorization by our Board, which enables management to repurchase approximately 2.37 million additional shares. We fundamentally believe in the long-term success of this business, and we're taking all the necessary steps to make sure that we're able to take advantage of that opportunity.

This company is well positioned to deliver on its goals and create significant value for our shareholders. We're supported by a healthy balance sheet and strong cash flow and an enhanced organization that can build on our momentum. We have a team in place to maximize our competitive advantage, and I'm confident in our ability to grow the business in the U.S. and internationally for many years to come.

With that, I'll turn the call over to Tim.

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Timothy G. Robinson, Medifast, Inc. - CFO [4]

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Thank you, Dan, and good afternoon, everyone. I'll review our financial results for the third quarter ended September 30, 2019, then I'll provide our fourth quarter guidance and discuss our 2019 outlook.

Revenue in the third quarter of 2019 increased 36.5% to a record $190.1 million from $139.2 million in the prior year period. We ended the quarter with a record 32,200 active earning coaches compared to 22,600 in the same period last year and 30,600 in the second quarter of this year. Average revenue per active earning coach for the quarter decreased slightly $5,715 compared to $5,781 for the third quarter last year.

We believe this slight decline was a result of operational headwinds that will continue to put downward pressure on this metric in the fourth quarter. We do expect average revenue per active earning coach to return to normal levels in 2020.

OPTAVIA branded products represented 78% of our total company consumable units in the third quarter compared to 70% in the prior year period. Gross profit for the third quarter of 2019 increased 33.3% to $142.9 million compared to $107.2 million in the prior year period. Gross profit margin as a percentage of net revenue decreased 180 basis points, 75.2% versus 77% in the third quarter of 2018. Decrease in gross profit margin percentage was driven largely by higher shipping expenses and higher product returns related to disruptions that Dan mentioned earlier.

SG&A for the third quarter of 2019 increased $33 million to $122.7 million compared to $89.7 million for the third quarter of 2018. The increase is primarily a result of higher variable costs, such as OPTAVIA commission expense and credit card processing fees, along with higher costs for our highly successful annual convention held in July, and increase in consulting costs related to information technology projects.

Lastly, as Dan mentioned, we had a significant increase in costs in the quarter related to the use of stolen identities and credit cards from outside our systems, to transact business on our e-commerce sites. We estimate the total impact on SG&A in the quarter related to these transactions was approximately $3.2 million, which is approximately $2.8 million higher than the prior year period. These expenses were primarily comprised of higher bad debt expense and credit card transaction fees.

We successfully addressed the situation and brought bad debt levels down to levels that are consistent with historic performance. We do not anticipate any material ongoing expenses related to this matter going forward.

SG&A as a percentage of sales increased 10 basis points to 64.5% of total revenue compared to 64.4% in the third quarter of 2018. Our effective tax rate was 22.7% in both the third quarter of 2019 and 2018. The effective tax rate was negatively impacted by the tax effects of foreign operating results, offset by favorable effects of state income taxes.

Net income in the third quarter of 2019 was $15.9 million or $1.32 per diluted share, based on approximately 12.1 million shares outstanding. Third quarter 2018 net income was $13.8 million or $1.14 per diluted share-based on approximately 12.1 million shares outstanding.

Our balance sheet remains very strong with stockholders' equity of $111.2 million and working capital of $80.8 million as of September 30, 2019. Cash, cash equivalents and investment securities, as of September 30, 2019, decreased $4.1 million to $96.9 million compared to $101 million at December 31, 2018.

The company remains free of interest-bearing debt. Inventory increased $13 million to $51.9 million as of September 30, 2019, compared to $38.9 million at December 31, 2018, due to advanced preparations for new international products, the initial production of the new Habits of Health system and a continued effort to maintain inventory levels to meet current and future demand.

Our Board of Directors declared a quarterly cash dividend in the third quarter of $8.8 million or $0.75 per share payable on November 7. We also repurchased approximately 225,000 shares during the third quarter. Following this repurchase, our Board of Directors authorized an additional 2 million shares for repurchase. There are now approximately 2,369,000 shares of common stock remaining under our share repurchase program. Our management team and Board of Directors remain committed to enhancing value for our stockholders.

Now turning to our guidance. We expect the fourth quarter revenue to be in the range of $157 million to $167 million, and EPS to be in the range of $1.03 to $1.13. For the full year 2019, we are updating our guidance and now expecting revenue in the range of $700 million to $710 million, and EPS to be in the range of $5.80 to $5.90. Our fiscal year 2019 guidance assumes a 21% to 22% effective tax rate, exclusive of any discrete tax benefits from share-based compensation awards best seen in the fourth quarter.

Our revised guidance reflects the second half impact of the short-term headwinds that Dan described earlier related to credit card-related bad debt and migration around both our technology and our supply chain. The company is in solid financial position, and the fundamentals of our business remains strong. We're confident in the future growth prospects and are focused on delivering our goals in order to create long-term shareholder value.

Well, that concludes our operational and financial review. We appreciate your interest in Medifast. Dan and I are now available to take your questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions)

Today's first question comes from Linda Bolton-Weiser of D.A. Davidson.

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Linda Ann Bolton-Weiser, D.A. Davidson & Co., Research Division - Senior Research Analyst [2]

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So sorry if I didn't quite catch all the explanation. But I guess what I'm a little confused about is, did this fraudulent activity occur in the third quarter? And if so, why is it the fourth quarter results just seem much more impacted than the third quarter? That would be my first question.

And secondly, I'm not sure I kind of understand -- I mean, obviously, this doesn't sound good that there's fraudulent activity here. But how does it like affect the coaches? Because they just are misled about what their downline earnings are, but how does that actually affect the servicing of their existing clients, as long as those clients are getting their orders? So maybe you could just give a little more color about exactly what's going on.

And then my third question is, clearly, these are IT problems. And we've had a little sense in the last year, so there's certain deadlines have slipped on your IT front. So are you making some personnel changes? Do you need to bring in special consultants to fix all this? And then just maybe restate again your estimation of when your business will be operating normally again? Will it be first quarter '20? Second quarter '20? Because the diet season is coming up.

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Daniel R. Chard, Medifast, Inc. - CEO & Director [3]

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Sure. And this is Dan. Let me add a little bit of color to what we just described. From the credit card standpoint, we'll give you a little bit more description. These were fraudulent credit cards and identities that were executed through computer bots, basically leveraging stolen identities and stolen credit cards, each of the credit cards' pay -- charges were authorized by the bank. The order was placed, the shipment was sent and then the bank came back and reported those as stolen.

So that's the impact to the company profitability. In terms of how it impacts the coach experience or the client experience, our coaches are very much tied and our business is very much tied to client acquisition. So each of these clients who comes in, who are tied to a stolen identity, don't repeat their purchase. So that has an impact on what coaches think they're doing from a business standpoint. So that's kind of the part of the headwind in terms of the coach experience.

Related to the IT problems. Yes, we have -- essentially, over the last 2 years, changed out every one of our critical systems. Each time we've done that, we've been replacing, in some cases, systems that are at end-of-life and have migrating data that's been on our systems for a while. So most of the challenges haven't been tied to the technology per se, but much of it has been tied to the specific migration of the data.

We have, over the past, I'll say, 9 months, hired significantly in the area and also brought on the top-tier partners to kind of help us through this in all these areas. Not just help us through this, but really to establish the platform going forward.

So I guess, to your last question, to restate when we think we'll return to normal. These issues with credit cards all happened in the second and third quarters. To the point when we realized by -- through being informed by the banks, we -- it was the third quarter. And at that point, we put in place technology to stop. So by the time we found out, put the technology in place to stop it, we had -- we effectively mitigated those issues by the end of the third quarter. So that specific credit card challenge was ended at the end of the third quarter. So we won't have that as a recurring challenge.

The other things that we mentioned, technology issues related to the changeover in our technology system. These are some very -- some fairly, I'll call them, minor bugs that's related to how our clients use our reordering platform and how they change their orders. And we became aware of those in the third quarter as well. And at this point, we've had 2 technology releases. So in this quarter, that have begun to fix those challenges, and we anticipate by the end of the quarter, those will be largely complete.

The last area, which I mentioned was a supply chain, I'll give you the easiest example to understand. We added about 40% capacity to our supply chain in the third quarter. It meant dismantling our pick lines, the distribution center that sold new equipment. And the interim solution involved changing our distribution processes for our supply chain employees. So the effect of that was some order of -- in order inaccuracies, and some impact on packing quality. So that was completed. So it started in May, and was completed by effectively mid-September. So the supply chain is now operating as it was before.

So we anticipate that through the fourth quarter, many of these problems are largely addressed. By the end of the fourth quarter, mostly addressed. And we expect client acquisition to reach -- and client retention to return to normal in the first and -- first and second quarter of the new year.

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Linda Ann Bolton-Weiser, D.A. Davidson & Co., Research Division - Senior Research Analyst [4]

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Can I have one follow-up question? So if there was ordering and then shipment of products that was false, are you saying that your revenue in the second and third quarters was false?

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Timothy G. Robinson, Medifast, Inc. - CFO [5]

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Linda, this is Tim. I'm sorry, my voice is shot, but no. So this is a legitimate revenue. We took an order, we shipped the products, it's bad debt expense. And some of this happened in the second quarter, some of it happened in the third quarter, but the expense all hit for most part in the third quarter. So the proper accounting for that is revenue and bad debt expense.

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Linda Ann Bolton-Weiser, D.A. Davidson & Co., Research Division - Senior Research Analyst [6]

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So again, why is the fourth quarter, the fourth quarter, that's disappointing us on earnings? And not the second and third quarters?

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Daniel R. Chard, Medifast, Inc. - CEO & Director [7]

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So third quarter was impacted largely by profitability. The fourth quarter, as you're aware, Linda, the most important activity that happens in our coach model is the acquisition of clients. Because the client acquisition or -- was impacted through the 3 areas that I described, and retention was affected, we're going into the fourth quarter with a lower number of clients. So that's why, as Tim mentioned, we anticipate some downward pressure on client product -- or coach productivity into the fourth quarter.

Then as client retention and acquisition returns to normal, as these 3 areas of -- as credit card, the credit card challenge is fixed. Supply chain returns to normal, and the technology fixes are in place. We anticipate that client acquisition and client retention will return to normal.

So it's -- the fourth quarter drag is a result of entering the fourth quarter with a lower client -- total client-coach account than we would normally have.

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Operator [8]

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Our next question today comes from Doug Lane of Lane Research.

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Douglas Matthai Lane, Lane Research - Principal & Director of Research [9]

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Staying on that thought, Dan. Your coach number in the quarter was actually a little bit better than what I was looking for. So I want to try to parse through all these cross currents. And what you're seeing the impact is at the top with your coaches? So far, nothing. But maybe that's the last thing to be residually impacted. So when we're looking at the fourth quarter, you're halfway through it and probably through the seasonally most important part of it, have you seen a slowdown at the top levels of your coaches?

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Daniel R. Chard, Medifast, Inc. - CEO & Director [10]

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Yes, Doug. We met with our top sales leaders, coach leaders in Sundance just a month ago. And we described to them the challenges we were facing, specifically, rate of technology and supply chain and described to them the plan to address those issues.

So they've, obviously, been experiencing the things that we described in terms of lower client retention and lower client satisfaction. Together, we work through what it would take to have everything return to normal.

And then, as I mentioned as well, we put 2 promotions in place, client acquisition promotions, to help generate the activity we need in the fourth quarter to get things back to where they should be.

So I would say our coach community is positive. They understand why we experienced these headwinds or cross currents, as you referred to them, and how we're getting back to the normal state and how they can then take the activity or the promotions we have in place for the fourth quarter and start doing what they do well, which is acquiring clients, helping them get on plan on their health journey. And then helping a portion of those clients become coaches.

So we anticipate all of these things are very short-term oriented, we've identified them, and there's nothing kind of fundamental in the deeper aspects of the business or the confidence of our coaches that's been affected.

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Douglas Matthai Lane, Lane Research - Principal & Director of Research [11]

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That's important. And Dan, you've gone through a rapid growth phase here. And I'm always concerned with hyper growth, with these kind of models, and you made it through a year ago at hyper growth, and now we're starting to see a little bit of strain on your infrastructure, both the financial, the ERP implementation, the supply chain. Have you thought about what is the Board's position? Or have you thought about internally expanding your senior management roles because throughout this you've added managers in the mid-level. For sure, you've added physical capacity and now IT capacity but, for instance, but there's no Chief Operating Officer here. How much do you think, given what's going on in the last 6 to 9 months, that maybe it's time to beef up the senior management roles?

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Daniel R. Chard, Medifast, Inc. - CEO & Director [12]

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I think, as I expressed earlier, we've added a lot of breadth and experience to our senior management level, so I'm confident in our senior management team. Again, I think if we saw some real missteps, meaning that things that were systemic, and that would drive deeper into the overall supply chain strategy, IT strategy, I think we'd be more concerned about that. But the issues that I've described. And I mean, don't get me wrong, they've -- it's been a very difficult quarter as we work through them and focused on addressing the issues completely. But the issues I've described are largely started and will end in the course of 2 quarters.

And so we -- what we've put in place from everything from our technology platform to our supply chain platform is in place and found -- and the foundation is solid and ready to deliver on our long-term set of goals, which are to grow our active earning coaches to 50,000, which will allow us to achieve our $1 billion goal. And we believe we can do that as we leverage our infrastructure and grow our operating margin to 15% or better.

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Douglas Matthai Lane, Lane Research - Principal & Director of Research [13]

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Okay. Just lastly, Tim. When you went in the -- when you started talking about the ERP system, probably on the first quarter conference call. And I think you had a number of $5 million to $8 million to implement it, which is viewed pretty much as a onetime kind of expense. Can you update us on that number and then indicate maybe the time period? It sounds like it won't just be 2019, that there'll be some residual spending on ERP in the first half of 2020. Any added information there?

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Timothy G. Robinson, Medifast, Inc. - CFO [14]

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Yes, I'll do my best here. Sorry, the -- yes, sorry. So we've been able to pull back on some of our spend this year by approximately about $0.5 million because we delayed the implementation. It will be a little bit tricky next year. We'll incur some additional expenses, but the accounting rules around cloud software are changing. We believe that starting next year, we'll be able to capitalize some of the costs that we've been expensing historically. So we haven't completed our outlook for next year, but I don't think it'll be a material impact on 2020 related to the delay.

The total cost impact is about $800,000 by shifting but a good portion of that $800,000 will get capitalized.

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Operator [15]

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(Operator Instructions)

Today's next question comes from Stephanie Wissink of Jefferies.

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Stephanie Marie Schiller Wissink, Jefferies LLC, Research Division - Equity Analyst and MD [16]

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Good afternoon, everyone. I'm wondering if we can just stay on this credit card situation a bit more. Can you talk a little bit about that customer falloff or maybe all 3 of the issues wrapped together. You mentioned customer retention a number of times. Do you look at the number of customers or clients? And if you can give us a sense of what that fall off might be. And then as you've described this, you've really talked about it as a bit of an air pocket. So the trend line is going to continue into 2020 based on the fundamental growth you've seen. Is that the best way to think about it, that this is really a Q3, Q4 pocket of onetime events? And we should start to see the business flowing consistently into 2020?

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Timothy G. Robinson, Medifast, Inc. - CFO [17]

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Yes, Stephanie. The -- as Dan mentioned, the credit card transactions affect both the company and the coaches as far as their outlook in the future. So typically, we have a customer, comes in, they repeat multiple times for many months.

And so even when we were doing our outlook, for example, for the third and fourth quarters, we didn't know it at the time, but there were thousands of transactions that were in our system that were never going to repeat. And so we did our forecast or our guidance for the full year. We actually raised our guidance based on what we were seeing.

The same thing happens to coaches, they expect a certain amount of repeatability to a new client as well as trying to reach out to a -- one of these credit card clients and the frustration of never hearing back from them is also an inefficient use of their time.

So it kind of just affects the coach and the company, to some degree, in the same way. You have this kind of false business in your outlook that never comes to fruition. And you can imagine for a coach, it probably affects their motivation as well. When they think they reached the threshold only to find out that the business never comes through in the following month. So it's very frustrating for a coach as well.

So that's how the credit card transactions kind of affected our Q4. It's more in that the activities not there that we thought was going to be there. And so customer retention is affected by 2 separate things: One is this credit card information that you also see a dramatic falloff of customers that you didn't expect; and then the other is just from client experience. We're seeing the propensity of customers that were acquired in the past quarter or so not stay as long, because we believe they haven't had a positive experience. So once we return that experience back to normal, there's no reason that we believe that client behaviors, I'll say, won't return to normal.

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Stephanie Marie Schiller Wissink, Jefferies LLC, Research Division - Equity Analyst and MD [18]

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Okay. And then if we think about the total cost, I think you mentioned a little over 3.5 million, but that's just for the credit card event, right? Not the total drag from the 3 technology-related events?

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Timothy G. Robinson, Medifast, Inc. - CFO [19]

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Yes, it's credit card, and I'll say credit card related. So it includes the bad debt, it includes other costs related to the bad debt.

So for example, we brought a professional firm in to help us stop it. We had additional credit card transaction fees. Every time we had an attempt, we'd pay a fee to check the validity of that card. So the $3.2 million is the total cost related to the bad debt transaction. It has nothing to do with the other 2 items.

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Stephanie Marie Schiller Wissink, Jefferies LLC, Research Division - Equity Analyst and MD [20]

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Okay. And then finally, can you just talk about the remediation efforts. It sounds like you put in a technology layer that's helpful to validate the authenticity of the cards. Can you just talk a little bit more about that, just so we understand that what you're seeing in your business today isn't still being impacted by some of this fraudulent activity?

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Daniel R. Chard, Medifast, Inc. - CEO & Director [21]

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Yes, the technology layer is a security software that essentially uses an outside database to first look at credit cards, and then it also looks at certain transaction types. We're able to program in the logic. So we had a very quickly -- climbed the learning curve and understanding exactly what was happening and programmed the logic in to address those specific types of transactions. And very quickly, we were able to get the bad debt expense back down to a normal level.

But it happened very, very quickly. As I mentioned before, it was -- used computer bots, stolen identities. And so during the initial phase, it wasn't apparent what was happening because the credit cards were being authorized by the banks. They came across our systems as looking like they were legitimate individuals with legitimate credit cards. And by the time the bank told us that they were reported as stolen, the shipment has already gone out.

So the software addresses that activity in an automated way. And we continue to monitor, obviously, this on a daily basis. But we have effectively returned it all the way back down to where it's -- the level of bad debt has been historically. So it's -- the issue is -- that specific issue is behind it, and we're confident in the vendors we're using to help us ensure the security of our systems going forward.

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Stephanie Marie Schiller Wissink, Jefferies LLC, Research Division - Equity Analyst and MD [22]

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A final one for us. Just on your fourth quarter guidance, does it contemplate any improvement from the current trend of business? So if the supply chain and the technology migration were to be less of a factor, would that provide upside opportunity? Or have you built in some improvement into the fourth quarter as the quarter progresses?

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Timothy G. Robinson, Medifast, Inc. - CFO [23]

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Yes. I think, Steph, I think we tried to be conservative. Go ahead, Dan.

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Daniel R. Chard, Medifast, Inc. - CEO & Director [24]

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We try to be conservative in the guidance. Like I said, we believe we have a good handle on the issues and the resolution. And we've basically re-prioritized all of the projects to allow us to quickly and effectively mitigate any of the headwinds that were being created by these last 2 issues from the supply chain side, which -- I mean, that one is complete. And then the last one is the technology side.

So we believe that there's no reason that our client retention and client acquisition won't return to the normal level, particularly, as I mentioned, because we've put in place some incentives to help our coaches through the challenging size -- the challenging side of the business that's been created by the headwinds.

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Operator [25]

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And ladies and gentlemen, this concludes the question-and-answer session. I'd like to turn the conference back over to the management team for any final remarks.

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Daniel R. Chard, Medifast, Inc. - CEO & Director [26]

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Well, thank you, everybody, for joining us tonight. We appreciate all your interest and your participation in today's call. Tim and I look forward to speaking with you again when we report our fourth quarter and fiscal 2019 financial results. Have a nice evening.

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Operator [27]

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And thank you, sir. Today's conference has now concluded. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful evening.