I usually don’t pay much attention to quarterly earnings releases, but I received the following email from a reader:

Curious as to your thoughts on WTW’s release. Here are mine:

-I was expecting meeting attendance and revenues to fall. This has been the trend and probably will continue. The question here is, why is it falling and what will change it.

-I did not expect that the # of active internet subscribers would be down QoQ. This is hopefully due to the proliferation of the free weight loss apps which has been discussed before.

-What stood out to me most is the marketing spend was down almost 30%. My guess is this:

WTW management understands that there is currently a large amount of free apps available.

They realize that the only time to successfully re-acquire customers from those apps is AFTER the customer has actually tried to use the apps to lose weight, and presumably failed. Essentially, management needs to wait them out. Combine this with the fact that we are in the pre-holiday season, I think the strategy may be to sit tight for a while.

As they wait, I think the trend is in WTW’s favor: http://www.cdc.gov/obesity/data/adult.html

Towards the bottom of the page is a map illustrating the increase in obesity from the 1980s through 2010.

WTW’s third quarter results were nothing short of a disaster.  Third quarter 2013 results include:

  • Revenues of $393.9 million, down 8.5% on a constant currency basis versus the prior year period
  • Meetings fees down 11%
  • Internet fees up slightly
  • Global attendance in the third quarter of fiscal 2013 declined 15.5% in comparison to the third quarter of fiscal 2012.
  • WeightWatchers.com experienced a decline of 2.6% in Online paid weeks versus the prior year period.
  • Operating income margin improved 100bps to 31.6%, benefiting from cost savings initiatives
  • Marketing expense down 29%
  • EBIT down 11%
  • EPS down 6%
  • The Company also announced that they expect Q4 revenue to be down double digits and a low double digit revenue decline in 2014.

Most importantly, the Company announced that it was suspending the quarterly dividend (Back in August, we wrote:  “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.”  I guess it wasn’t sacrosanct after all.).

As the reader notes, the biggest surprises were the drop in Online paid weeks and the crop in marketing expense. In the 10-Q, the Company noted that “(t)his is the first time in our history that Online paid weeks declined on a year-over-year basis.”  In the earlier write-up, I stated:  “The Internet, by lowering the barriers to entry, takes away any competitive advantages WTW might have had.”  I did not expect WTW to work well online, I simply did not expect it to happen this quickly.

Regarding marketing expense, the Company acknowledges that the business is very marketing-driven but believes that marketing spend as a percentage of sales had simply gotten out of hand.  Marketing expense as a percentage of revenue had shot up from 14.3% in 2009 to 18.8% in 2012.  They are taking it down to 16.7% in 2013 and expect it to remain at that level in 2014.  I also think that the reader is partially right that they want to hold back funds for the traditional January push.

The third quarter earnings call and the subsequent Investor Day presentation were both pretty remarkable for their candor.  On the earnings call, the CEO stated:

“I see now that this situation we are facing as a business and organization is more difficult than it originally appeared. Although our third quarter profit results exceeded our expectations as a result of strong cost management, it is clear that our top line momentum is weak across nearly all our business lines and geographies with steep declines in recruitment being the principal cause. This weakness has accelerated as we have moved further into 2013 and will continue into the fourth quarter and calendar year 2014 as the wave of free apps stealing trial in the category continues to adversely impact our online recruitments in particular.

“Notwithstanding their easily understandable appeal, we do not believe that free apps will solve the obesity epidemic. We do believe that Weight Watchers is best positioned to do so, but we need to change to accomplish it. That having been said, I want to be clear: I believe we can transform this company, but we have a lot of work to do to finalize, validate and deliver our strategic initiatives and achieve our potential. It will take time. There is no silver bullet.”

One positive to come out of this is that the Company announced a major push into the healthcare market – a move we consider welcome growth investment inside the moat.

To be certain, Mr. Gannon did not expect the future to be rosy.  He projected EPS of $3.50 by 2017.  The Company recently announced their goal is to hit $2 billion of revenue by 2018.  Given their 10-year average net income margin of 14.87% and assuming shares outstanding stays flat, this would give them EPS of $4.88 – well above Mr. Gannon’s estimate.  Mr. Gannon’s thesis rests more on a change of investor sentiment and an increase in the P/E than an improvement in business results.  This turnaround plan only provides upside for Mr. Gannon.

Lastly, as I stated in my original write-up, I agree with the reader that the overall trend in obesity works in WTW’s long-term favor.  However, in the new world where the Meetings business is deemphasized, I simply don’t see any durable competitive advantages that would allow WTW to generate outsized returns.