UPDATE: On February 17, 2010, Medifast Inc. filed suit in US District Court, Southern District of California, alleging defamation, violation of California Corporations Code, and unfair business practices. On March 29, 2011, Judge Janis Sammartino dismissed all of Medifast’s claims against me in her ruling on my anti-SLAPP motion.

So who is short selling Medifast (NYSE:MED) stock? I’m not, but apparently plenty of other people are. (No, Medifast, I have no idea who it is, nor do I care who it is. That’s your problem. Not mine.)

As my readers already know, Medifast is on the hunt for anyone who would dare to say something less than flattering about the company. I’m being sued, along with others, for having a low opinion of Medifast’s Take Shape For Life (TSFL) division. Shame on me for voicing my negative opinion of a multi-level marketing scheme, and Medifast will MAKE ME PAY for daring to oppose them.

I am happy to report, however, that I’m not the only one who questions Medifast’s business model. Last week an article was posted at Fool.com about the amount of short selling activity around Medifast. Short selling is a bet that a company’s stock price will fall, and some like short selling overvalued companies.

It was reported that Medifast has a current short interest of 18.8%, which is said to be high. More than a 5% short interest is often said to be a warning sign that there is something wrong at a company. The writer of the article looked at Medifast’s current ratio, and deemed it very strong. He found that Medifast’s free cash flow has been trailing earnings, but did not deem this a problem with this company. Finally, the author looked at the company’s PEG ratio and determined that it is within line with the company’s expected growth.

What could explain the high instance of shorting Medifast, then? The author says it’s possible investors feel the company is overestimating its growth potential.

In general, the author also says that financial “…red flags like accelerating revenue recognition, aggressive acquisitions to hide underlying financial weakness, and changes in reporting methods can only be spotted by carefully analyzing the notes companies bury deep in their filings.”

In the case of Medifast, its growth is almost solely because of growth in the multi-level marketing Take Shape for Life division. Could this be the problem hidden in the financials? I believe so. Aggressive growth in MLMs is difficult to sustain because it requires a constant stream of recruiting of new distributors into the system.

Medifast has a questionable product with limited appeal. It is a super low calorie plan, made up of mostly powdered foods… just add water!

Sure, diet foods are in high demand, but I don’t think Medifast has one that is all that attractive to most consumers. MLMs use the product as the hook to bring in distributors, although in my research, I have found that the products in MLMs are usually of marginal quality and they truly take a back seat to the sale of the opportunity. (i.e. MLMs are selling the recruiting aspect much more than they’re really trying to sell a product to third-party consumers.)

The predicted growth of the company is closely tied to the ability of TSFL to continue to recruit new coaches at a continued high rate. I don’t think that’s going to happen.