2 ugly ducklings to consider for a dividend growth portfolio
Sometimes you come across a business that looks fantastic at first glance. Everything seems in place. Growing earnings, rapid dividend growth, history of dividend growth, low leverage, low payout ratios, reasonable growth expectations, basically anything you want to see as a dividend growth investor. But then you look under the hood and what you find makes you cringe a bit.
Medifast (MED) and Primerica (NYSE: PRI). I eventually initiated small roles in both earlier this year, but spent most of the previous two years debating whether I believed in the future of the company. Both of these companies have business models that make me “uncomfortable”.
However, I can’t deny that all the metrics from these companies are amazing. And it finally overcame my fear of owning them. Well, partially, at least, I can’t bring myself to take a full-fledged position on either. But I’ll lay out the details of both and let you decide.
On the Yahoo Finance site, here is the summary of what Medifast does:
“Medifast, Inc., through its subsidiaries, manufactures and distributes weight loss, weight management, healthy living, and other consumable health and nutritional products in the United States and Asia- The Company offers bars, bites, pretzels, puffs, cereal crunches, drinks, hearty choices, oatmeal, pancakes, pudding, soft desserts, shakes, smoothies , soft pastries and soups under the brand names OPTAVIA, Optimal Health by Take Shape for Life and Flavors of Home.point-of-sale transactions on an e-commerce platform.The company was founded in 1980 and is headquartered in located in Baltimore, Maryland.
The company looks quite promising in today’s health-conscious world from this description. Weight loss is a colossal undertaking; it seems like everyone is constantly on a diet. So what’s the problem?
The challenge of investing in the company is its business model. It is an MLM, multilevel marketing system. If you’re not familiar with an MLM, it’s basically a pyramid scheme where existing members promote and sell products to new people and encourage them to do the same. Members are the marketing and sales force. The problem with MLMs is that in the end, there is no one left to bring into the network, and the pyramid collapses.
You’ll love finance and valuation if you can live with the business model. In the Fastgraph below from Medifast, you can see that the company is trading well below its historical norm. The graph also shows the explosive growth that Medifast has experienced and the significant growth expected over the next two years. The company has a long-term growth target of 15%; of course, the management is still optimistic.
On the dividend growth side, the business is exciting! The company only has a seven-year dividend growth history; However, it has seen massive dividend growth. Three- and five-year dividend growth rates are above 40%, although this year’s increase was a slight 15%. Yet a 15% growth rate is equivalent to a doubling approximately every five years. If the company is hitting its growth targets, maintaining that pace should be achievable. While it’s difficult to use historical dividends to value companies with such a short dividend history, the current starting yield of 3.5% is the highest yield ever offered, outside of pandemic lows. The graph below shows the dividend yield over the past seven years.
While the pandemic has done little to slow Medifast’s growth, the current environment may be a different story. As inflation affects the company’s revenue, it remains to be seen how well the company will be able to pass on these costs. The company derives 90% of its revenue from subscriptions, but people start to rate the services when subscriptions increase. I believe that over the next two years, Medifast will struggle to meet its growth targets.
Here’s a low-leverage, fast-growing, cash-generating company. In fact, the company enjoys better profit margins than 70%, as shown in the table below. The company has very little debt and is not in a capital-intensive industry. With a PE of 11 and double-digit growth, this company is a clear boon in today’s still overvalued market. Although everything looks positive for the company, I recommend building a position slowly because in the short term the road may not be as rosy as the financials would indicate. However, today’s prices will prove to be a bargain in the long run.
One barrier to investing in insurance companies is the relatively low barrier to entry. Interestingly, even with low barriers, it’s only in recent years that we’ve seen anyone questioning existing business models. Primerica is one such company, and its actions can be punished for being different.
Primerica could essentially be considered an insurance MLM. His clients also tend to become his agents. In 2021, the company had nearly 130,000 licensed independent life insurance representatives. By comparison, Prudential (PRU) has 20,000 insurance agents. To put that into more perspective, Prudential collected about 27 times Primerica’s revenue last year; although the product line comes into play, obviously Primerica works differently. Of course, just as most Medifast salespeople aren’t full-time, the vast majority of Primerica agents are part-time.
Just because Primerica is different doesn’t mean the company isn’t performing well. Over the past decade, the company has grown its earnings per share by an average of 17% per year. While earnings growth has been impressive, cash flow from operations has been staggering. And as a dividend growth investor, cash flow is important because, ultimately, dividends are paid out of cash flow. Primerica achieved a whopping 30% average growth in operating cash flow per share over the same period.
Compared to its competitors, Primerica has higher leverage relative to its size. However, this debt has an A-S&P rating. The company regularly buys back its shares and, as a small-cap company, it doesn’t need large dollar-value buybacks to move the needle. Its currently authorized redemption through the end of 2022 is $325 million, or nearly 6.5% of its market capitalization. More importantly, the company appears to be repurchasing at reasonable valuations, which few companies accomplish. The chart below shows the impact of takeovers over the past decade.
As a dividend-growing company, Primerica has experienced rapid dividend growth. It has three- and five-year dividend growth rates in excess of 20%. The most recent increase was a slower 17%, but at that rate the dividend would double roughly every four and a quarter years. Notably, the payout ratio is a measly 16%, where it has hovered for the past decade. The ability to quickly increase the dividend without increasing the payout ratio is a sign that the company’s dividend growth may continue in the future.
Primerica is not a high-yield company. As the chart above shows, the current yield of around 1.7% is the highest yield ever offered, except for the flash crash of 2020, where it briefly topped 2%. The company has averaged much closer to a 1% return over the past decade, so today’s valuation is a significant yield-based bargain.
The Fastgraph below shows Primerica’s relative undervaluation today based on PE ratios. The current PE of less than 11 is below the historical norm of 13.7, further indicating that Primerica is in trading territory. However, Primerica appears to be at an average valuation compared to other insurance companies. Thus, an investor should consider the quality of Primerica relative to its larger peers before jumping in with both feet.
Both Medifast and Primerica have unusual business models. These companies are highly profitable and have a history of growing their dividends. Importantly, by any measure, these companies have shown the ability to rapidly increase their dividends. With low payout ratios and double-digit growth forecasts, they should continue to do so in the future.
Right now, both companies look like fantastic bargains relative to their historical PEs and dividend yields. However, Primerica’s PE is currently in line with its competitors, even though all of its metrics point to a bargain. I am currently adding to both, but am doing so cautiously given the general state of the market.