Well-known value investing blogger Geoff Gannon recently announced a significant investment in Weight Watchers (“WTW” or the “Company”). Mr. Gannon’s remarks on this investment have been brief so it is not entirely clear what his thesis is. However, he seems to be attracted to the Company for its proven weight loss method (I assume this is what he means by “psychologically powerful”), high free cash flow, low reinvestment rates and aggressive share buybacks. Mr. Gannon also likes that investor sentiment has soured with the recent CEO change and reduced earnings outlook. He acknowledges that the business will be bad for the next few years due to a “marketing miss” and estimates 2017 EPS to be $3.50 on the low end (roughly 17% lower than 2012). But, he believes the P/E multiple will rise from ~8 to 15. Essentially, he argues, Weight Watchers is a high quality company that is being over-penalized for short-term issues. Has Mr. Market given us a classic value investing bargain – a household name business at its 2 year low?
Like Mr. Gannon, we are always interested in companies with low capital requirements, high margins, a powerful brand and sticky customers, especially after a significant drop in price. We decided to do a deeper dive on WTW to determine whether the current problems really are short term or whether a complete turnaround is needed.
The Weight Management Industry
WTW participates in the weight management industry. The weight management industry is highly fragmented and highly varied. Here is a brief list of just some of the market participants:
- Diet soft drinks
- Artificial sweeteners
- Health clubs
- Commercial weight loss centers
- Low cal/diet foods
- Retail & multi-level meal replacements, diet pills
- Bariatric surgery
- Prescription diet drugs
- Bariatricians’ plans
- Hospital, clinic, MD plans
- Diet books, cassettes, exercise videos
Competition is fierce but industry participants may not compete against each other directly.
The industry is prone to rapid and continuous change. Low carb diets, gastric bypass surgery, and calorie counting apps are just a few of the changes that have hit the diet industry in the past 10 years.
The market is expanding rapidly for reasons covered elsewhere. Suffice it to say that we as a nation are fat and getting fatter.
This industry is characterized by high search costs for consumers. Consumers are at a stark disadvantage in this area because the benefits are largely psychological and subjective while the differences are difficult to ascertain. Because comparison is difficult, consumers have a high risk of making a disappointing purchase or even falling for an outright fraud. Consequently, buyers tend to rely heavily on even small amounts of direct experience (trial purchases), on endorsements, and on their prior experience with a brand.
The high cost of search gives known brands a large competitive advantage. A brand leader’s advantage lies in customers’ satisfactory prior experience and resulting reputation. Until experienced, a new brand offers only a promise to perform as well which cannot be tested until purchased and tried. Consequently, established brands can recast the purchase in terms of the psychological value of avoiding a mistake. For example, WTW routinely dismisses new entrants as mere “fads.”
Does Weight Watchers Have a Moat?
Our key metric for determining whether there is a moat is Return on Invested Capital (ROIC)[1]. WTW’s ROIC is infinite as it should be. It takes almost no hard assets to run this business. They also collect payment from customers in advance, driving net working capital negative. Another key metric, steady and predictable free cash flow, is not as rosy as it has increased at just 1.92% CAGR over the past 10 years (See Chart 1). Market share stability, a third metric, is difficult to calculate because of the amorphous nature of the industry. If the industry is defined as diet centers, they have virtually no competition. But if we look at the weight management industry as a whole, they are but one ant among many in a highly-fragmented market.
CHART 1 (click to expand)
A qualitative look at the Weight Watchers moat requires us to look at each segment individually.
The Traditional Meetings Business
WTW’s largest segment is the traditional meetings business which generates ~72% of revenue. We can make a strong case for a moat in the meetings business due to the following competitive advantages:
- Search Costs – As described above, consumers have high search costs in this market. Weight Watchers benefits from being a brand leader. The Weight Watchers brand stands for competence in an industry rife with false claims.
- Network Effect – The meetings business benefits from a network effect, a product that becomes more useful to all participants as the number of participants increases. One of the keys to the meetings business is the quality of the leaders. The best leaders want to work for the most ubiquitous company. In turn, customers prefer the convenience the high number of locations creates and the better leaders. Thus, WTW’s locations create a network effect:
- Weight Watchers has the most meeting locations and the most scale
- WTW attracts the most customers because it is the most convenient and/or has the greatest brand awareness
- Meetings leaders choose to sign up for WTW as opposed to competitors because WTW generates the most revenue
- WTW captures more share, allowing it to open more locations
- More leaders sign up for the WTW network
This network effect is limited to just the diet center sub-industry. It does not help WTW in competing against companies outside this sector.
- Habit – For obvious reasons, WTW does not publish its recidivism rate but it is believed to be fairly high. WTW can count on a fair amount of repeat business.
- Economies of Scale – The Company has economies of scale in marketing, but economies of scale are close to irrelevant in this business as fixed costs are very low.
Disturbingly though, the numbers fail to back up the finding of a moat. See Chart 2.
CHART 2 (click to expand)
At first glance, the revenue increases are impressive, particularly in light of a dramatic drop in attendance. However, aggressive franchise acquisitions are creating a distortion. In the 1960’s, the Company pursued an aggressive franchising to rapidly expand their geographic presence and build market share. Since 2001, the Company has embarked on a franchise acquisition strategy, acquiring over 20 franchise operations for over $700 million. Franchise operations currently account for less than 17% of the Company’s global attendance, down from ~33% at the end of 2002. The attendance figures cited by the Company include attendance increases due to acquired franchises. Similarly, the sales figures are artificially inflated since the franchise acquisitions allow the company to book all the revenue rather than just a 10% franchisee royalty. While it’s not possible to separate out organic growth, it’s clear that the slide would be much worse without the franchise acquisitions. Therefore, it seems that the operating margins tell the real story. The operating margin for the meetings business has been dropping steadily going from 33% in 2003 to 19% in 2012.
Mr. Gannon attributes some of the current troubles to a “marketing miss.” We would argue that instead the marketing win in 2011 is looking more and more like the anomaly. In our view, this should not be treated as if a consistent clothing retailer like The Gap (GPS) missed on inventory in an otherwise anomalous year. The meetings business, despite a big marketing win in 2011, is in secular decline. The moat in this business, if there ever was one, has been breached.
We are not sure what exactly took place but we can speculate. It’s hard to develop customer captivity in this business because it is intended to be a short term solution. That is, members are supposed to attend meetings for a relatively short time, attain their weight loss goal and then move on. Mechanisms for enhancing customer captivity, like loyalty points and long term subscription plans, are inappropriate. Further, the industry is constantly buffeted by new weight loss solutions. In this environment, WTW is forced to reacquire virtually all of its customers each and every year.
WeightWatchers.com
Bullish investors are counting on the smaller but faster growing WeightWatchers.com segment to offset declines in the traditional business. Rather than providing emotional support through group meetings, WeightWatchers.com provides tools for the self-help weight management market. The growth has been phenomenal, growing from essentially nothing in 2003 to $507 million of revenue in 2012. WeightWatchers.com now provides 28% of the revenue and 51% of the operating profit of the Company. Margins are also outstanding, hitting 51% each of the last 2 years. See Chart 3.
CHART 3 (click to expand)
A deeper look shows clouds gathering on the horizon.
A quick look at Apple’s App Store shows dozens of free or nearly free dieting apps. A calorie-counting app from MyFitnessPal is the most popular fitness app in both Apple’s iTunes store and the Google Play store, offering a free option to compete with Weight Watchers’ online program, which costs $18.95 a month. Activity trackers like Fitbit and Nike’s FuelBand also help calorie-conscious consumers track how many calories they burn when they walk, jog or work out. On the Q2 earnings call, the CFO acknowledged the drop in recruitment of new members and attributed it to “the continued sudden explosion of interest in free apps and activity monitors.”
What competitive advantages could WTW possibly have online? By moving on to the Web in the first place, Weight Watchers gave up what had made it unique – convenient locations, well-trained leaders and face-to-face emotional support. The search costs advantage discussed above disappears online. On the Web, the Weight Watchers tools are no more attractive than dozens of other apps, many of which are free. The Internet, by lowering the barriers to entry, takes away any competitive advantages WTW might have had.
WTW might have brand loyalty on the Internet but the free competitors are giving a portion of the market a product that is “good enough.” We have no idea whether these apps work, and the Company thinks they are but a short-lived fad, but anecdotal evidence suggests that the simple act of having to enter everything you eat into an app inhibits overeating. This can be combined with online social networks for an experience that replicates WTW.
Some commentators believe WTW missed an opportunity by not matching the new entrants with a free app of their own. This action would have merely postponed the inevitable. If WTW had met “free” with “free”, it might have had an impact on their ultimate share, but it would not have altered the structural dynamics of the industry. It’s hard to compete when low barriers to entry enable dozens of competitors to make a comparable product and give it away for free.
Debt
Management has presided over a large increase in debt over the past 10 years, jumping from $446 million in 2003 to $2.4 billion today. See Chart 4. The Company was able to modify their loan agreements so the debt matures in 2016 and 2020. However, the refinanced debt is not particularly cheap at 3.3%. We do not see any short term liquidity crunch, but the situation could become grave if fundamentals continue to deteriorate.
CHART 4 (click to expand)
Cash needed to service the debt is beginning to crowd out other uses. The dividend, which we hope is sacrosanct, and debt repayment averaged 66% of FCF over the past 5 years. See Chart 5. Management announced that a highly publicized marketing campaign aimed at men has been cancelled. We fear other investments will also be pushed aside (more on this below).
CHART 5 (click to expand)
Management and Capital Allocation
As mentioned earlier, part of Mr. Gannon’s thesis rests on the large amount of free cash flow that the Company generates. In this, he is certainly correct. Given the Company’s low reinvestment needs, Weight Watchers generates far more cash than it needs for operations. But, can management be trusted to invest the money in a way that benefits minority shareholders? The majority owner of WTW,is Artal Group SA, a private equity firm, has not always allocated capital in an efficient manner. Over the past 10 years, the Company has returned an average of 129% of free cash flow to shareholders via share buyback and dividends. However, if we exclude in the two big, misguided buybacks in 2007 and 2012 (more on this below), the average drops to just 44%.
We favor three uses for the cash: (1) Share Buybacks, (2) Dividends and (3) Growth Opportunities Inside the Moat.
Share Buybacks
We are certainly in favor of share buybacks and think they are a wonderful use of cash when done properly. To cash out, Artal initiated two large, debt-financed share buybacks. Both were ill timed: $54/share in 2007 and $82/share in 2012. There have been minor buybacks when the stock price has been significantly lower. Besides a waste of money, the debt burden leaves WTW cash constrained, particularly as we embark on a period of sharply dropping revenues.
Dividends
The Company’s dividend has remained flat at $.70 since 2007. The average payout ratio of dividends is just 14% of free cash flow. Given this dismal track record, its seems unlikely that the Company will increase the dividend any time soon.
Growth Opportunities Inside the Moat
Fortunately, the Company has stayed away from acquisitions outside the core franchise.
The big growth opportunity for WTW with in the moat would seem to be partnering with large employers and insurers looking to reduce obesity in order to reduce healthcare costs. This market will be more interested in the effectiveness of the program than consumers and WTW has the scale to get up to speed quickly. But will they have the cash to pursue it? Debt repayment and interest expense are eating up a bigger and bigger percent of FCF. Will the funds be available to pursue this opportunity? They have already been forced to eliminate their campaign aimed at men. Will the partnerships be next to go?
Valuation and Conclusion
At a 12% EBIT/EV yield (on 2012 EBIT), WTW is cheap but not dramatically so. Further, this seems to be a stock market investment rather than a business investment. Mr. Gannon’s analysis turns on Weight Watchers P/E multiple increasing from 8 to 15. We don’t like to rely on a speculative change in investor sentiment. Instead, we like to rely on improving business results to carry the day. As the name of the blog would suggest, we are not comfortable buying a stock that we would not want to own forever. Otherwise, the risk of a “value trap” is simply too high. Here, WTW simply has no durable competitive advantages. In the turbulent weight management sector, this makes forecasting future cash flows impossible and far too risky of an investment.
[1] Here, ROIC = EBIT / (Net Working Capital + Net Fixed Assets)
Punch Card Investing 
FCF/EV is not a valid metric to use. FCF/Mkt Cap or EBIT/EV is ok.
I have no idea what you are talking about. Why is EBIT/EV more valid than FCF/EV? You don’t believe in taking capex into account? Why is FCF/Market cap ok?
FCF/EV multiple is inconsistent, if your definition of FCF is net operating cash flow minus capex (thats free cash flow to //equity//).. a consistent multiple would be FCFE/Market cap or FCFF/EV (here free cash flow to firm) ..lets take FCFE/Market cap = 2050/271 ~ 13% yield ..i would call this CHEAP 😉 ..so we may argue if it is cheap enough in relation to its moat.. thats okay, but i wouldnt call a 13% free cash flow yield expensive.. and i know some really lousy businesses that trade at far higher multiples..
Best wishes,
nell
I think I get what you are saying now. If you want to use EV as the denominator, the numerator has to be a pre-interest expense income number. Is that correct? Similarly, if you want to use FCF as the numeraotr, the denominator has to be equity. Right?
Pingback: Some links | valueandopportunity
yes, thats correct..
OK, as for the next point, I’m not rendering an opinion whether its cheap or expensive relative to its moat. I’m just saying that its risky because it has a narrow moat or no moat at all. This makes it difficult if not impossible to project future FCF. As a result, I need more than a 13% FCF yield to invest. But, this isn’t my kind of an investment in any case.
“At a 6% FCF/EV yield (on 2012 FCF), WTW is not particularly cheap.” ..I would correct this line to get the numbers right.
* Thesis: FCF is not stable..
Here is a snipped from their 10-K 2012:
“As shown in the table above, our total paid weeks in our Company-owned operations grew from 130.2 million in fiscal 2008 to 210.7 million in fiscal 2012, or 12.8% on a compound annual growth basis. Weight Watchers Online paid weeks grew from 38.9 million in fiscal 2008 to 111.5 million in fiscal 2012, or 30.1% on a compound annual growth rate basis. Our total meeting paid weeks grew from 91.3 million in fiscal 2008 to 99.2 million in fiscal 2012, or 2.1% on a compound annual growth rate basis. Before the launch of our commitment plans in the meetings business, our members were largely on a “pay-as-you-go” basis, and accordingly, growth in meeting attendance essentially approximated growth in meeting paid weeks. However, paid weeks and attendance are no longer directly correlated as the percentage of meeting paid weeks attributable to commitment plans far exceeds the percentage attributable to “pay-as-you-go”.
Conclusion: Business is growing and those numbers include a rather harsh environment for their services as the consumer reduced their spending habbits 😉
Here is a snippet from their last call:
“Jerry R. Herman – Stifel, Nicolaus & Co., Inc., Research Division
I promise this will be my last question. It’s for Jim and it’s kind of comprehensive but if you can try and answer it in a succinct way, Jim, the question is how do you think about the growth rate for Weight Watchers? You got this tremendous market opportunity yet the key metric of measurements i.e. attendance, hasn’t really grown for the better part of a decade. You got high margins, strong cash flows, much of which goes to de-leverage the company, which is in part, reflective of your majority owners action. How do you think about the growth profile of Weight Watchers on a going forward basis with those inputs?
James R. Chambers
I think if you look at a measure of engagement, as we do, paid weeks, that has shown up to this year, consistent growth, I believe, for the last 5 years. So I can turn maybe a bit to the — what’s beneath your question, less on a quantified basis and more in general as to how I see the forces that might affect growth in the future for the company. And I did mention them a bit in the earlier remarks. I think there’s an extraordinary opportunity here. I don’t think I’ve ever worked in a business before where the potential market is as enormous as this is. I think it is a tricky category to market in but as Nick said, when we get those variables right, we can have tremendous impact. And I think historically, our product has been bifurcated between an online product and a meetings product. And as we look to the future and as we become much more consumer-driven in the way we construct our offerings, I think there’s a real opportunity to innovate and to offer something that will be stronger in the market. And my belief in that is strong and that, as a consequence as you would imagine, translates into a belief that I think we can improve growth rates over the long term. There’s a lot of work to do there. There’s a lot of conceptual thought. I hope to share more with you guys about that in November at the Analyst Strategy Day, but we have a lot of work to do but I’m bullish, driven by the fundamentals that we can create a good long-term outlook.”
Best wishes,
nell
I will make the correction.
WTW switched to weeks paid from meeting attendance as the key metric they trumpet to analysts a few years agao. I think its a BS stat that they use to divert attention from the dropping attendance figures. It doesn’t show any increase in customer captivity (or “engagement” as WTW says). It just shows that more people are paying in advance and then not showing up for meetings. I don’t think its as meaningful as attendance.
I read that exchange in the conference call and Gannon quoted the analyst’s question on his website. I think its a great question but the CEO’s response is meaningless. He essentially says its a huge market and we need to reinvent ourselves to grow. OK, fine but I don’t want to come along for the ride.
The industry is changing a lot, making future fcf harder to predict. Yes, you could look in the past and see stable fcf, but you could have said the same thing about newspapers. Last Q results give a good clue as to where the business may be headed. All I hear from mgmt is excuses.
I don’t see a big problem with fcf/ev in general. It’s good to be conservative by looking at fcf yield on an unleveraged basis. But most of the debt was used for poor capital allocation decision.
I agree but I usually use EBIT/EV. I don’t know why I didn’t here.
What’s wrong with FCF/EV? I think it makes sense in helping you look at the business from an owner’s perspective (or potential acquirer). Let’s say you’re a billionaire and have $20B in cash. You can buy 100% of WTW but to do so you’d be acquiring debt, less cash, so you’d be essentially paying $4B or so for it (EV from Ycharts). From that $4B you’re getting about $250M a year in stable FCF. $250/4000 = 6.3%. Look at Dell, they had sustainable FCF of $3B yet at one point it traded for $15B in early 2013 and eventually went private at a bargain price of $25B last week (12% FCF yield). Also look at AAPL, sustainable FCF of $30, maybe even $40B, and it traded at an EV of just $300B when Icahn went public with owning it. Asa business owner I’d be looking at the cash I could take out if I owned the whole company. Am I missing something here?
Thanks for a very interesting analysis!
Thanks!
great write up, I learned a lot.
Thank you, Steph.
EV/FCF is a perfectly reasonable metric. It incorporates all of the contractual payments as well as necessary investments that must be made prior to any stakeholder returns (either to equity or debt holders). To leave out financing costs basically makes a highly leveraged company look the same as a non levered one from an equity perspective. As you are not in a position to change the capital structure as a minority shareholder you have to take it as it is. Any payments to you as an equity holder, in theory, come behind those to the debt holders. This is particularly relevant in the case illustrated above where FCF is likely to be much lower in the near future, due to the effect of revenue declines on the negative working capital characteristics of the business (it’s great when its growing but is a killer when it shrinks). When the debt load is too big(as is the case here, IMO) EV/FCF is the more important metric as the company will likely need to prioritize debt repayment before other equity interests.
Is it possible that if there were no moats, we would have also seen apps take the place of Alcoholics Anonymous meetings? People still go to the meetings, because that group support and peer pressure is very valuable. Similarly, the online service could potentially yield better results because you have the “support” of a company whose logo (and point value) is placed on many products and in some restaurants. Compared to the other services, it also costs money, and that can make people feel invested and more likely to stick with their weight loss.
For what it’s worth, one completely non-statistical way to measure a moat could be times used in parody videos. This parody of the song “22” cites Weight Watchers as go to diet: http://www.youtube.com/watch?v=YSnDJ7exSO0
If nothing else, the video is funny.
Ok, a few substantive comments.
1. I have been to about 20 different meetings (I visited 10 locations twice each) and they are like religious events. I attend church and I honestly felt like I was in Sunday School. Class participation, sympathy with others undergoing similar struggles, sharing experiences, building on basic principles over and over. There is, for lack of a better word, a cult-like experience to it. I am about 5 pounds overweight and I almost signed up. I think this religious experience is something that My Fitness Pal cannot replicate (also something that the Atkins Diet or any other diet can’t replicate).
2. I really like financials, however, I think sometimes one can get lost in the weeds when trying to think about a business through its numbers. Weight Watchers was founded in 1963 by a housewife with no business experience. Their product is essentially meetings and discussions among similar people. To say there are no barriers to entry is a vast understatement. Yet, in 2013 Weight Watchers spends more in advertising than Nutrisystem generates in revenues (approximately). They are the 800-pound guerrilla in the diet industry. If this isn’t evidence of a moat somewhere, I don’t know what is. I guess my point here is, if a business is highly profitable and is easily replicable, yet competitors are few, isn’t this evidence of a moat? Ipso Facto?
3. Share Buybacks, Capital Structure: Speaking in approximate numbers, Weight Watchers was valued on a mostly equity basis at $5B before the “ill-timed” share buyback. Now, the equity is valued at $2.5B and the debt at another $2.5B. If you own a home with no mortgage valued at $500,000 and take out a $250,000 mortgage (i.e. get 250k in cash), this doesn’t change the value of the home, it just changes the capital structure. If a neighbor comes to you and asks to buy out your share, the price would now be $250k and the new owner would assume the $250k debt (assuming the bank would allow this assumption). Yes, it increases default risk, however, the home value is still the same.
Given that Weight Watchers has minimal to no taxable depreciation, carrying some level of debt is financially prudent from a tax perspective due to the interest charges on its debt being deductible. Weight Watchers has essentially swapped out one credit (the taxman) for another (its bondholders). Yes, the bondholder requires a fixed as opposed to variable (the taxman), but given Weight Watchers history some debt should be part of its capital structure.
4. Stick to Their Knitting: I think Weight Watchers has a great history of sticking to profitable business lines. The Weight Loss Industry is so diverse that, over the years, Weight Watchers could have used its cash flow to acquire any number of business-line extensions to provide “growth.” Instead, they have shown a remarkable consistency in being able to generate cash flow and showing an inclination to return a large majority of this to shareholders. In my view, its like See’s Candies. Weight Watchers could have expanded into exercise equipment in order to increase revenues, but that would have undercut their profitability. See’s doesn’t try to compete with Reese’s, instead See’s send its cash flow to Omaha….
I have no position on Weight Watchers’ current valuation, just wanted to comment because I do like the business.
Matt,
Thank you for your comments. They are thoughtful and well-considered. Here are my quick responses:
1. I too love the meeting side of the business. Maybe this got lost in my post, but I think it is a wide moat business. My concern, however, is that is in decline and is regularly buffeted by fad diets.
2. I remain completely agnostic on the effectiveness of the WTW approach. My mother and wife are both fans. Interestingly though, neither of them stick with it or have given them any money in years.
3. I have no problem with a high FCF company like WTW taking on debt. In fact, I think it was exactly the right decision. I am, however, highly critical of ill-timed buy-backs. They would have been better off paying a dividend.
4. I guess I marginally prefer ill-timed buy-backs to poorly thought-out growth investments.
Again, thank you for your comments.
Andy
Pingback: Analys av Weight Watchers International | Värdebyrån
Pingback: Update on Weight Watchers International, Inc. (WTW) | Punchcard Investing
Pingback: Who Ate Weight Watchers's Lunch? | Student of Value
Pingback: Analys Weight Watchers International 2014 | Analysakademin
What’s the lesson here since Weight Watchers has totally tanked since this article was written?
A. Always, always start with Enterprise Value. P/E ratios are totally worthless and blinded by companies with debt or high cash
B. Firms with high debt are higher risk and require higher discount rates
C. Estimate future FCFs using the higher discount rate – what initially looked like a bargain suddenly becomes an easy “pass”
D. High debt and a “pass” – there might be opportunity buying the bonds of the company, not the stock
E. If you aren’t totally sure, give up and move on to something you are sure of
F. Never stop learning. In the meantime, take small bets until you are sure you are good, and never before!!!