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). 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.
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.
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.
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.
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.
 Here, ROIC = EBIT / (Net Working Capital + Net Fixed Assets)