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:
I hope to own a collection of great businesses; to ever sell one, I 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.