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Why I Bought Weight Watchers

April 09, 2014 | About:
The Science of Hitting

The Science of Hitting

231 followers

A few weeks ago, I opened a small position in Weight Watchers (WTW) common stock. I’ve been watching the company for the past few quarters, and started taking a closer look at the financials as the business has struggled and the stock has been slaughtered (it has fallen approximately 75% in the past two years). Much of my initial research has piggybacked off of the work from “Gannon and Hoang on Investing” (link). I think they have a clear understanding of the challenges and opportunities WTW faces in the years ahead, and would suggest that anybody who is interested in the company should take a close look at the work they’ve done.

I’m writing this article under the assumption that you’ve looked at WTW, or at least read the most recent 10-K. If you haven’t, I would offer the friendly suggestion that you take the time to do so. I would also suggest that you watch the Investor Day presentation from November and read all the commentary from James Chambers since he became the company’s CEO last year. Mr. Chambers has been forthright about the company’s problems in his communication with shareholders to date; I’m not sure I would have made this investment if that was not the case.

To summarize my thoughts out front, I do not believe free apps will be successful for the large majority of individuals that use them over time; the same can be said for smart watches, fitness bands and other activity monitors. Weight Watchers isn’t a solution for everybody, and it doesn’t need to be. I think the numbers I'll discuss point to a large enough addressable market for the company to be successful — even as the alternatives mentioned above become more prevalent.

Let’s start with an example: As noted in a Boston Business Journal article last month (here), the Lose It! weight loss app (set a daily calorie budget, track food and exercise) has “more than 17 million users in the U.S. and Canada who have lost a combined 28 million pounds with the help of the app.”

The quick math shows that’s less than two pounds lost per user; if we assume 10 pounds of weight loss as the metric for success that would mean, at most, 2.8 million users have lost their desired amount of weight with the program – a success rate against a relatively low hurdle of less than 20%. (I say that’s a low hurdle for this reason: The CDC estimates that 36% of adults over the age of 20 are obese, meaning a BMI over 30; as an example, an average height woman would need to lose 30 pounds to go from a BMI of 30 to break into the high end of the healthy weight range.)

I can’t find similar metrics on MyFitnessPal’s 50 million users (and counting), but I would bet they paint a similar picture. The number of users the free apps have racked up is pretty impressive — but the figures suggest that few people have been successful if their goal was material weight loss. The results for comparable events, like MOOC’s (here), show what we all know intuitively: It’s much easier to start or signup for something, especially when it’s free, than it is to see it through to completion. Sadly, even those who are successful will have a tough time maintaining their target weight: Nearly 65% of dieters return to their pre-dieting weight within three years, according to Gary Foster Ph.D., clinical director of the Weight and Eating Disorders Program at the University of Pennsylvania (source).

Losing weight and keeping it off is difficult, particularly as increasingly sedentary lifestyles become the norm; by CDC estimates (here), nearly 70% of adults over the age of 20 in the U.S. are overweight (BMI in range of 25 to 30) or obese. Most people do not have the willpower to start and stick to a weight loss plan on their own; the idea that people will have widespread success by tracking calorie consumption on their phones is a fallacy in my view (however, I would make the argument that paying for that app/service could act as a psychological component that would increase the average success rate; I have no way to confirm this belief, but I think it could be material).

In the investment community, I think usage — or more appropriately, downloads — have been mistaken for a viable alternative to Weight Watchers' proven model; over time, I do not think that will play out. In my view, this is a fad in a different form. At its peak, nearly 10% of Americans were on Atkins; a year later, as the low-carb fad faded, that number was down to about 2%, according to the Washington Post (link).

Another factor to consider is the market size; it is estimated by Weight Watchers' internal research that more than 100 million adults in the U.S. are trying to lose weight; while some pursue exercising alone, the vast majority (about 85%) include dieting as well (or alone). Of those 85 million (or so) individuals, there’s a breakdown into a few buckets: The majority of those 85 million people (about 70%) stick to their own plan; of the remainder, there’s a mix of free app usage, book/magazine plans, pills and other dietary supplements, and finally commercial plans like Weight Watchers. As you’re thinking about these numbers, remember that Weight Watchers has approximately 3 million users globally — a small sliver of the pie.

To think that mobile app usage means the death of Weight Watchers is much like the “death of PC” talk from a few years back — hardly substantiated by the facts, but difficult to eliminate as completely ludicrous; I think these situations tend to result in favorable risk/reward balances. As Microsoft (MSFT) has shown, capitalizing upon these periods of market wackiness can be lucrative — investors who purchased MSFT in late 2010 and early 2011 (when Google Trends shows a spike in interest for “death of the PC”) are sitting on gains of 50% to 70% before dividends. I think you can make a strong case that even after those gains MSFT is not expensive.

To come up with a rough target for WTW, I used the company’s 2013 Investor Day presentation, namely slide 61 (“Financial Aspirations”). On that slide, management lays out a 2018 revenue target of more than $2 billion, with about 80% from the B2C business and roughly 20% from the B2B business. I decided to take a decent haircut on those estimates, and used a 2018 target of $1.8 billion on the top line (this would require 6.5% annual sales growth from the $1.4 billion target for fiscal 2014).

Working through the income statement, I assumed gross margins were 10% lower than the historical average for conservatism (49.6% versus a trailing 10-year average of 55.3%); I also assumed marketing would be at 15% of sales (in line with the 10-year average), and that SG&A would be at 14% of sales, equal to the cap set by management at the 2013 Investor Day. It should be noted that when sales hit $1.8 billion for the first time (2012), SG&A was about 11.5% of sales.

In my calculation, I also assumed that interest expense (via debt reduction) would be 25% below the 2014 estimate (which was built upon management estimates on the fourth quarter call); reducing the debt balance by 25% would require roughly $600 million to be removed in the next four to five years — equal to $125 million to $150 million per annum (management’s a bit more aggressive in their estimate, looking to bring the total down roughly $900 million by 2018).

Over the last decade, Weight Watchers has returned about $370 million a year to shareholders through dividends and repurchases; with both of those eliminated for the forseeable future, the company’s free cash flow can be spent entirely on reducing debt outstanding. The company’s trailing FCF in the past six years (including the recession) averaged more than $260 million a year — easily enough to match the debt repayment timeline I highlighted above.

After adjusting for taxes and shares outstanding, I estimate that fiscal 2018 earnings should be in excess of $3 per share. Assuming a multiple of 10x on after-tax earnings, that brings the stock price to $30 or more per share (by my math, the trailing five-year average on a monthly basis is about 15x earnings). Buying the stock for under $20 and assuming it will get to $30 in the ensuing four years means 50% upside — good for a compounded annual return of nearly 11% per annum.

I'm confident that those numbers are sufficiently conservative; I think there’s a margin of safety in purchasing WTW shares at or below the $20 mark. I think 2014 will be a very difficult year for the company, one which will include a lot of noise as smart watches and other activity monitors continue to be in the spotlight (the next iteration of iOS is expected to come with a built-in Healthbook app as well). To put this difficulty in numbers, Morningstar’s analyst was looking for about $3 per share in earnings for fiscal 2014 prior to the fourth quarter call; the midpoint of management’s target turned out to be more than 50% below that figure (at $1.45 per share).

Of course, investing isn’t about what will happen in the next 12 months — it’s about the value of the cash flows from now until perpetuity, discounted at the appropriate rate. Valuation metrics that look at P/E or EV/EBITDA in the next year alone would suggest that Weight Watchers was worth at least twice as much in 2011 as it will be in 2014 — a proposition that I find nonsensical.

The market is currently putting significant weight on what will happen in the ensuing 12 to 24 months; if Weight Watchers' management team cannot find a way to differentiate its offering and offer value to consumers above and beyond free alternatives, then that will prove to be justified. I think this management team has a grasp of the problems WTW is facing, and has enunciated a clear plan of attack for addressing these issues going forward.

To be clear, I don’t think this is a sure thing; much like with Staples (SPLS), I think the company has a clear opportunity to fill a niche that fits nicely with what they currently excel at — but that doesn’t assure success. Weight Watchers has a better business, but Staples has a stronger balance sheet; both companies have difficulties ahead that may be gut-wrenching for individuals who are not clear on what they’re getting into. As always, investing requires a steady head — the availability of daily pricing from Mr. Market is irresistible for many; if you can’t purchase this stock and then sit with indifference as it moves by 10% over a short period of time, then I think you’re kidding yourself if you do not view your activity as speculation.

At recent prices, I believe Weight Watchers is a sensible investment for long-term investors.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 3.9/5 (11 votes)

Voters:

Comments

MritikCapital
MritikCapital - 3 months ago

Hi Scienece,

Few thoughts ...

The business does not have a strong economic moat and debt is higher relative to decreasing EBITDA (from my understanding). I guess you are looking for a business to buy when out of favor for a turnaround and then flip/sell.

A Buffett style value investor would say (a) Most turnarounds never turn (b) Time is the friend of a wonderful business and enemy of the mediocre.

On a side node It will be interessting to see how HLF turns out for Icahn and Ackman as well.

It does take a lot of resolve to hold picks like JCP, SPLS, WTW. Some investors did good on HPQ, BBY,DELL last year. My problem with these type of investments is that you need to be able to sell out at the right time (which is only obvious in hindsight)

I wish you Good Luck with the pick. Look forward to an update article in a year or two.

arurao7
Arurao7 - 3 months ago

Science:

You just bought this stock, and one of the other commentators "jae jun" on gurufocus just felt the exact opposite. This is what makes the market.

To take this a step further, I have always wondered what to do, when some of the gurus are on the opposite side of the trade. Think MBIA (Marty whitman and bill ackman) as an example. It is no wonder that buffet says he reads a lot, because knowing the moat of a business is a very difficult qualitative issue.

Morningstar has a good way to analyze this. They call it "moat trend" (I am sure you are very aware of this) and they do mention that WTW has a 'negative moat trend'. It may be a classic buy-low sell-high stock, but not sure of long-term, because you are betting that they will strengthen the moat that is weakening, and their attendance will climb back AND STAY OR GROW!

Good luck with your investment.

rrurban
Rrurban premium member - 3 months ago

I appreciate your analysis but this is a very risky company and people don't fully appreciate the risk they are taking owning WTW because they believe in the brand name/moat/etc.

Bottom line: WTW's debt payments are roughly $200M per year (P+I). FCF is $250M and declining. They have $175M in cash. Current ratio is .9. This is cutting it close. WTW is a turn-around, let's call it what it is. Turn-arounds are very stressful for CEOs and CFOs and don't expect them to stay around for long if this trend continues. Besides, what real experience does either have at a real-life turn-around? Expect turnover at the top of the company within the next year. SG&A is way too high right now and needs to decrease while attempting to preserve the core business, if possible, but SG&A needs to decrease...period. Even assuming they can cut expenses while preserving the dividend, we will be waiting a very long time for earnings to increase. EPS ttm $3.87, EPS estimates next year $1.41. Yes, the analysts are not historically entirely accurate, but they are just listening to management given the fact that there is an absence of EPS visibility, so this is the "best guess" we all have. The debt load is an end-gamer should FCF continue to fall. For 11% a year return I would not take this risk. Now, at $10 a share, I would consider changing my mind (as long as I buy a LEAP put as insurance).

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Mritik - Just to be clear, is it your opinion that this company has never had an economic moat, or that something has materially diminished / eliminated the moat as of late? Want to make sure I understand what I'm responding to. Do you attribute any value to the company's consistent top rating against its competitors (US News & World Report has ranked it the #1 weight loss diet for each of the last five years), or its proven efficacy in countless studies over the past few decades - do you think that's all meaningless PR / marketing? Thanks for the comment - look forward to your response!

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Arurao7 - There needs to be somebody else on the other side :) I would note that from how I read his article, he must have believed that WTW was worth $45-$50 per share a few months / quarters ago (he's said he was down 40%, so buy price was ~$35; 30% upside to FV gets the price to ~$46). I'm not nearly that confident, as I tried to convey here. I've noticed some interesting things on SG&A / operating leverage in my research, but I don't want this comment to get too long; maybe the start of another article in the future. Thanks for the comment!

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Rrurban - It's not the brand name as much as the proven efficacy of the system, which is reflected in consistently solid ratings from third parties and success with its members; don't take my word for it - go read the recent Baylor study if you're interested. Here's one interesting section of note: "This is the first study to examine the three complementary ways to access the community-based Weight Watchers weight-loss program – meetings, mobile applications and online tools. Among the 147 participants assigned to the Weight Watchers group, those who used all three access routes together to a high degree (attendance at more than 50 percent of the weekly meetings and use of the mobile applications and online tools at least twice a week) lost the most weight, 19 pounds. Those using two access routes to a high degree lost 9.5 pounds and those using one lost 9.3 pounds. Meeting attendance was the strongest predictor of weight loss. Participants with a high degree of attendance were 11.2 times more likely to lose 5% of their body weight and 15.5 times more likely to lose 10%, as compared to those with a low degree of attendance." Now, what can management do with that information? That's what I'll be watching closely in the coming months. Thanks for the comment!

MritikCapital
MritikCapital - 3 months ago

Science - Just to be clear I have not followed this company as closely as you and analyzed as much as you. I respect the fact that you analysis is detailed. The concern I see at first look with WTW is that company may not have the pricing power due to lot of new competition. I think pricing power is a very good indication of moat and as others have raised moat is narrow and might erode over time. I am sure the company will survive for the long term but I wonder whether long term intrinsic value will grow or not.

twcooper3
Twcooper3 - 3 months ago

I own WTW and would never have bought it if I thought it was a turnaround. WTW's moat is its effectiveness and its large advertising budget. If a more effective program comes along, the moat will be gone. Fads come and go, just like Atkins. This is not a turnaround story, this is a muddle-through-the-fad story. There remains, however, the legitimate risk of a capital raise.

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Mritik - That was a serious question, not a snarky comment or anything like that; there could be a good reason / something I'm missing on that front - I just don't see it. I agree with you on pricing power to some extent; if your competition is mobile apps (and it is to some extent), "free" is hard to compete with. As I noted, I think that's only a small subset of their competiton - and that most of those people will not be successful with those tools. Then you get into online tools that can become / are similar to WTW, like Retrofit (check it out); however, their cheapest service is $148/month - multiples of the most expensive offering from WTW. Time will tell; thanks for the response!

bwokocha13
Bwokocha13 - 3 months ago

WTW is hard to ignore for a value investor considering the historical FCF and margins. From a market perspective, the opportunity is still there considering the success of the program for weight loss and the staggering numbers associated with obesity. I do find it odd you didn't mention Artal Group considering their majority ownership and control of the board. Twice over the past 5 years they have bought back stock at crazy valuations (loading the company with debt and cashing out Artal) to the dismay of shareholders. No matter the debate about WTW going forward it is hard to partner with a majority owner whose interests are not aligned with other shareholders.

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Bwokocha13 - I've thought about Artal Group a lot, and certainly have issues with the most recent tender (which has put the company in the somewhat precarious financial position they currently find themselves in). Their capital allocation history is certainly worth discussing - but I don't think it's the primary issue at this time. WTW will not be repurchasing shares or paying dividends for a few years, at least; that would be my biggest area of concern as it relates to Artal going forward. I would note that Artal did not change their ownership as a result of those repurchases; their stake is ~51% as of the most recent proxy, not too far below where they were a decade ago (56%). If you think there's a bigger issue here that I'm missing I would like to hear your thoughts; thanks for the comment!

batbeer2
Batbeer2 premium member - 3 months ago

>> If you think there's a bigger issue here that I'm missing I would like to hear your thoughts; thanks for the comment!

I don't know if it's a bigger issue but I think it's worth noting.

For many years, the website was a joint venture of WTW and Artal. Then after the website had grown, Artal sold their stake to WTW for a big profit. So I think it is fair to say minority shareholders didn't gain as much as they could have from the growth of the website.

I'd say it's not OK when a controlling shareholder sells an asset they own to the business they control. Especially if that asset subsequently has issues.

If you look into this deal and draw different conclusions, please let me know.

pravchaw
Pravchaw premium member - 3 months ago

This remains one of my biggest concern, Artal using WTW as personal piggy bank to raid every few years to the detriment of the minority share holders.

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Batbeer - From what I see, WTW increased their stake in WW.com from 20% to 53% in June 2005 by exercising warrants and buying shares from WW.com employees not related to Artal; they then paid $305M to Artal for the remaining 47% (implied value of ~$650M) at an identical price per share as paid to the employees. Since that time, WW.com has grown from ~410,000 active online members to ~1.7 million in 2013; revenues increased from $109M to $527M, with operating income increasing from ~$50M in 2006 to $300M+ in 2013. To be clear, I agree with you - I do not think that a controlling shareholder should have a large stake in a strategic asset and subsequently sell it to the company; I also believe that the share repurchases were ill-timed and questionable. Going forward, particularly in the near term, I think any such concerns are less relevant than they've been in the past; time will tell whether I've made a miscalculation here.

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Pravchaw - Since 2006, WTW has paid a bit over $400M in dividends, paid to minority shareholders and Artal alike. The issue, as you likely know, comes from the ~$1B repurchase in 2007 and ~$1.5B repurchase in 2012, both of which look atrocious with hindsight. But let's remember something that I think is overlooked: their overall ownership has been essentially unchanged in the past decade; Artal's percentage ownership in WTW did not change as a result of the repurchase at ~$82 per share in 2012. Going forward, I think these concerns are further down the list, as a large repurchase is clearly not in the cards anytime soon. As noted in my comment to BatBeer, time well tell whether I've made a miscalculation here. Either way, I should've spent more time discussing Artal in the article, for which I apologize; thanks for the comments!

AlbertaSunwapta
AlbertaSunwapta - 3 months ago

Has anyone attempted to calculate its intrinsic value?

The Science of Hitting
The Science of Hitting premium member - 3 months ago

Alberta - The short answer is I think the business is conservatively worth at least $1.5 billion; I'm comfortable purchasing shares at a valuation of ~$1.1 billion. You can take this for what it's worth, but trailing 10-year average net income is more than $200M, with a trailing 10-year average EBIT of more than $400 million; obviously you must decide whether those numbers are representive of what WTW can attain going forward, or good times now gone forever. Thanks for the comment!

vgm
Vgm - 3 months ago

"Has anyone attempted to calculate its intrinsic value?"

AS - Yes, recently here on GF:

http://www.gurufocus.com/news/254106/weight-watchers-shares-are-worth-5388-

yuruvalue
Yuruvalue - 2 months ago

Science,

Can you please elaborate for me on why you view your $1.8bn revenue target as realistic? I suspect you don't erosion in meeting numbers and prices from online apps and competitors taking share, but I'm interested to hear more on why you've taken management's targets as your base and your beliefs behind those.

yuruvalue.

SeaBud
SeaBud premium member - 2 months ago

Couple thoughts from somebody who has watched WW for a year but not pulled the trigger:

- WW is not a fad. It does not rely on eating a magic product or avoiding a devil product (ie, carbs). It is simple calorie counting and is one of the most effective weight loss systems out there, as proven by studies.

- WW has a terrible balance sheet that was largely self inflicted.

- WW is perceived to be the same as freebie apps. Why pay for calorie counting when you can get it for free? Some truth there, but most weight issues are mental and it is undeniable that day to day discipline and conviction mean as much as the system selected. Free apps promote little to none of that.

- WW must work this "life coach" message into its operations and marketing. Without it, they have a shrinking moat.

The low valuation and historical business made me look at WW. The shrinking moat with little apparent answer have made me hesitant to buy, but the debt have me holding back. If they generate nice FCF, use it to address debt, and even stabalize revenue, I will buy.

Please leave your comment:


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