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Waiting for Weight Watchers

Like so many other gamblin' Fools, I love Vegas. Seriously. Hook me up to an IV catheter, and I might not ever leave the poker table. (Especially after my most recent trip.) But, alas, Vegas has its drawbacks. The biggest is how I eat when I'm there. Farm animals eat better than I do on a Vegas bender.

So by the time you read this, I'll be home and already on a program to detoxify. That is, I'll be mixing in a few greens with each meal and getting out and walking more than the few feet to my desk. And you can bet Weight Watchers (NYSE: WTW  ) will be a big part of the program.

My wife first turned us on to Weight Watchers more than four years ago after our son was born. She's still on it, even though she doesn't need to be because, well, it works. She's healthier and more beautiful now than she has ever been. (No, this isn't some giant public suck-up. It's true.)

Go ahead, chow down
Weight Watchers is the world's largest provider of products and services for helping people lose weight. The firm operates in 30 countries and has been around for 40 years. According to Yahoo! Finance, trailing 12-month sales equaled $973 million.

Unlike other weight-loss approaches that ask you to cut something, Weight Watchers asks only that its clients maintain a balance. Want to eat too much chocolate? OK, bucko, see you on the treadmill. Prefer a salad for dinner? Good girl, here's a slice of apple pie. Weight Watchers makes it a point to say yes when others, such as the low-carb alternatives, say no, no, no.

Weight Watchers makes money by helping customers reach and maintain their ideal weight. Most of the cash comes from membership fees and branded product sales. And its deal with former parent Heinz (NYSE: HNZ  ) generates a fair amount of licensing business through lending the Weight Watchers stamp of approval to healthy food choices, such as Nestle's Lean Cuisine and ConAgra's (NYSE: CAG  ) Healthy Choice. The most recent example is a partnership with restaurateur Applebee's (Nasdaq: APPB  ) , which in May announced 10 new Weight Watchers-driven menu items at its 1,600 nationwide locations.

High-carb heaven
The main reason I've been watching Weight Watchers is because I'm not totally convinced that high-carb meals are a thing of the past. For one, coffee is a huge no-no, according to the late low-carb pioneer Dr. Robert Atkins. But looking at Starbucks' (Nasdaq: SBUX  ) recent quarterly results, it seems the sage advice is falling on millions of deaf ears.

Indeed, there are profits to be made in high-carb heaven. Take The Cheesecake Factory (Nasdaq: CAKE  ) , for example. The restaurant and bakery features healthy items and delicious treats on its diversified menu, and its results are to die for.

It's not that I think the world is on the verge of a low-carb revolt and tomorrow will start demanding Krispy Kreme (NYSE: KKD  ) Original Glazed on ice, as well as in the box. But flexibility and variety matter, and diets get, well, boring.

Yet another meeting
That said, the low-carb craze hassqueezed Weight Watchers like a pair of tight-fitting pants. Exactly three months after predicting a strong 2004 in which it would earn between $1.90 and $2.00 per fully diluted share, management reported in the first quarter that annual net income was more likely to come in between $1.70 and $1.80, or 10% lower than anticipated. Investors ran from the stock.

Part of the problem is that not enough people are showing up to Weight Watchers' 46,000-plus weekly meetings around the globe. Although Weight Watchers says its meetings are attended by 1.5 million people, market researcher Value Line reports that North American attendance, after adjusting for acquisitions, was down 2% last year, and there's no sign of a pickup.

That's not good, especially when you consider that meetings are the firm's cash cow, generating 64% of total revenue last quarter. Unless Weight Watchers finds a way to regain clients who've fled to low-carb alternatives such as the Atkins and South Beach diets, sales and earnings are unlikely to improve much.

A not-so-quick fix
Of course, I tell this to my wife, and she blurts out how she doesn't believe it, that meetings here in the Denver metro area are packed to the gills, many with low-carb refugees. It's sometimes hard to take such anecdotal evidence seriously as an investor. But, then again, that's exactly what superinvestor Peter Lynch advocates in his investing classic, One Up on Wall Street, when he tells readers to get out and visit a shopping mall every once in a while to troll for stock ideas. (Although I think you might do better watching Oprah or trying one of our investing newsletters.)

Frankly, she could be right. (It wouldn't be the first time.) Two landmark research reports published last year indicate that as great as the low-carb diets are for shedding pounds fast, they aren't as prolific for keeping weight off over a six- and 12-month period. And then there is the widely reported speculation that the Atkins diet may not be heart healthy because of its propensity to favor cholesterol-filled foods. Should either prove true over time, Weight Watchers' membership could bulk up fast.

For its part, Weight Watchers appears to believe a reversal is all but inevitable, preparing a welcome-back promotion for carb-craving carnivores.

Healthy free cash flow
What I like most about Weight Watchers is its fiber-filled business model. I'm talking the green variety, as in moolah. The business creates a ton of free cash flow.

Weight Watchers generated more free cash flow than net income in each of the last two full fiscal years and did it again in the first quarter. Since going public in 2001, the firm's free cash flow has grown at an average annual rate of roughly 25% and again looks to top $200 million during 2004. Over the same period, net income is down slightly.

It's unclear at this point whether free cash flow will continue growing at such a rapid pace, but management's reduced expectations for net income this year would still amount to nearly 30% earnings growth from 2003. That bodes well. And so does its deal with Heinz to take back ownership of third-party food licenses that bring annual royalty payments of more than $4 million.

A tasty prospect?
As sexy a prospect Weight Watchers is, there are many risks, especially in the short term. Low-carb diets won't just go away. And Weight Watchers still carries more than $400 million in debt, which doesn't exactly make for a svelte balance sheet.

Further, its valuation is a little on the heavy side, trading for roughly 20 times 2003 free cash flow when compared to its enterprise value. That's a discount compared with its historical cash flow growth rate, but I'd prefer to see it cheaper because of the risks. But should the stock touch a slim and trim 18 times free cash flow, or roughly $33 a share, you can bet I'll be putting our money where my mouth is.

Motley Fool contributorTim Beyersis always hungry. Hey, is that your fridge? Got anything to eat? Tim owns no interest in any of the stocks mentioned, and you can view his Fool profilehere. The Motley Fool has adisclosure policy.

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