A historic view of recurring themes in major wartime conflicts, our puzzling tendency to continuously overeat, and the pie-in-the-sky popularity of Charles Duhigg's The Power of Habit reveals a telling bit of human nature. We don't change bad habits, despite knowing better.
Better or worse, that's why I'm purchasing shares of Weight Watchers (NYSE: WTW ) equal to 3% of my Real Money Portfolio's capital. Our collective waistlines are expanding, at an ever-increasing rate. And in an industry dominated by snake-oil remedies, quick fixes and faddish diets, and short-termist solutions, Weight Watchers' clinically proven, decades-old approach to weight loss management and behavior modification stands apart.
On the heels of recent marketing missteps, an ill-timed share repurchase (that ballooned its debt burdens), and broader concerns over the health of its online and meetings businesses, Weight Watchers' shares have shed a few pounds -- roughly 30% off 52 week highs, and 50% from all-time highs set two years ago.
The result: a capital-light business with sustainable competitive advantages, a history of superior returns on capital, and excellent free cash generation trades at 8 times trailing free cash flow. The stock market's priced Weight Watchers as a business in decline, but its target market is only getting, er, larger. To wit: According to the World Health Organization, worldwide obesity has almost doubled from 1980, and worldwide, 1.4 billion adults were considered overweight.
A healthy business
Weight Watchers started as many entrepreneurial ventures do: a vision in someone's basement. In 1961, founder Jean Nidetch started holding weight-loss meetings with overweight friends in the basement of her NYC apartment building, sharing her learnings after attending an obesity clinic. Together, they saw results, via virtuous cycle -- supporting each other, advising on good habits, and, most importantly, remaining accountable.
In the time since, Weight Watchers has evolved and grown, becoming the world's foremost network of weight-loss plans and tools, meetings, and related products. In its current incarnation, Weight Watchers' business is somewhat different: 51% of 2012 revenue derived from meeting fees, 28% from its Internet-based tools and offerings, and the remainder from licensing arrangements, ad revenues, and franchise royalties. Its approach has also evolved, to one that increasingly emphasizes empirically validated weight loss methods alongside behavior modification, coupled to the psychological benefits from support networks.
In doing so, it's created powerful competitive advantages. For one, its brand stands apart -- 80 medical journals have reported statistically significant weight loss among program participants, validating its approach. For its customers, a single factor sets it apart: a proven method. Absent a plan, it's difficult to identify how to correct bad habits. Weight Watchers attacks this from several angles. Its meetings offer the power of networks and accountability, on a global scale. Online tools allow customers to log diet plans, access recipes, and effectively integrate various foods into diet plans. Taken together, they create two powerful loops: network effects in the meetings, and switching costs in its online tools (because information is logged there).
Most significantly, despite its dominant market position, the diet industry is still relatively fragmented, leaving significant growth potential. At current, Weight Watchers only owns 5% of an estimate
Are shares worth a bite?
But recently, shares have been hit, for reasons I've already referenced -- a tough 2013 marketing effort and according declines to membership, concerns over competition from free (or cheaper) apps, and debt assumed to finance a value-destroying share repurchase in 2012. Concerning? A little. But I believe the market's unduly discounted these stressors, and after considering the value in its online business, we're getting Weight Watchers' meetings business and an option on future growth for free.
1. Losing weight? A poorly received 2013 product launch, blithe marketing copy, and concerns that free apps and other Internet-based solutions are eating into Weight Watchers' market have put a hurt on shares. There's some truth to it all: U.S. meeting revenue declined 7.4% in the first quarter, International meeting revenue slipped 11.1%, and the company's guidance calls for earnings per share to decline 10% at the midpoint, even after repurchasing 25% of its shares in 2012. This has prompted concerns. Online revenue grew at just 10.4% in the first quarter after years of 20% or greater revenue growth, prompting concern that free apps (or cheaper alternatives) are indeed taking share.
Is the worst to come? I don't think so. For one, the market size, and growth potential, is large enough that Weight Watchers can lose share, and still grow. Likewise, a contingent of its customers represent a relatively recurring source of revenue -- as switching costs (from entering meal plans, caloric intake, and storing recipes) keep them coming back -- and a select group will benefit from and relatively continuously attend meetings. Last, where free online competitors and the Hydroxycuts of the world peddle solutions endorsed by "doctors," the strength of Weight Watchers' brand, history of clinical effectiveness, and concretely defined plans provide a degree of credibility competitors lack.
Most importantly, this needn't be a winner-take-all game: To be a successful investment, Weight Watchers doesn't have to secure world domination. Its shares are priced as if the business won't grow, at all.
2. Buy one, get one: Currently, the market is, in effect, giving us the meetings business, product sales (nutritional bars and snacks, scales, and various publications), and licensing revenue for free. Last year, the online segment generated $260 million worth of operating income. After netting enterprise-wide interest expense and taxes out, and assigning a 17.5 times earnings multiple (the market multiple), it's worth almost $2 billion. Weight Watchers' current market cap is $2.4 billion. But remember: Meetings, product sales, and licensing made $250 million in operating income last year -- about the same as online.
3. A share repurchase and debt: Last year, management repurchased roughly 25% of shares outstanding. I might champion that behavior, were it for an important fact: The price was positively outrageous and, in doing so, destroyed value for shareholders. Worse, the company assumed $1.6 billion worth of debt -- nearly tripling its burden. All of this has given rise to concerns that, if meeting revenues continue to slide, Weight Watchers may violate its debt covenants.
I'd wager those concerns unfounded. There's actually a silver lining for would-be purchasers. If profits from meeting revenues, licensing, and product sales were almost halved, the company probably wouldn't violate its covenants. In short, I'm not too concerned. Instead, I expect Weight Watchers to pay down debt via its copious cash generation and, in the process, accrue value to shareholders -- as perceived risk declines, and it renegotiates interest rates on remaining debt.
4. An option on health care: Last, there's one big growth option. It's wild-eyed, but not altogether impossible. What if Weight Watchers were to partner with insurance companies?
So what it's all worth? Two ways to skin a cat here. My discounted cash flow analysis assumes that Weight Watchers is able to grow revenue at a 4% to 5% clip across the mid-term, as growth from online subscribers offsets near-term declines to meeting attendance, the company passes intermittent price increases, and an eventual, slow increase to meeting attendance contributes to operating margin expansion. On this basis, I estimate the shares' worth at $67.
Don't take my word, though. Weight Watchers has acquired franchisee operations at a relatively continuous clip over the years. At last year's close, it'd spent $778 million in total. In its financials, the company estimates that, should operating income declines anywhere between 3% and 50% (depending on geography), 89% of its acquired franchisees are worth three times the price paid, or about $2.1 billion. Take this, and add the online biz, whose worth I ballpark at about $2 billion, and the shares could be worth $74.
The risks to Weight Watchers are pretty clear. First are those from competitors, which, for reasons I mentioned above, I don't find particularly concerning. The company also faces more formidable, though less seasoned, competition in offerings from Herbalife (NYSE: HLF ) and Nutrisystem (NASDAQ: NTRI ) . Both companies' product offerings are respectable in their own right, but neither possesses the pedigree or extent of clinical support.
Next are weight-loss drugs. Most notable are Arena Pharmaceuticals' (NASDAQ: ARNA ) recently launched Belviq and Vivus' (NASDAQ: VVUS ) Qsymia. These represent a threat, but again, I don't think this is a winner-take-all proposition. Drugs are pricier, and, as Weight Watchers, are only likely to grab a relatively small proportion of the overall market. What'd concern me most? Continued missteps from management on product launches, marketing, or another ill-timed share repurchase. Even so, at today's prices, I believe the shares adequately account for these risks.
Last, Artal Group, a private equity firm, owns 44% of shares, and effectively controls the board. You might argue that last summer's tender offer was a cash-out for its private equity owners, and it wouldn't be unreasonable. Fortunately, at today's prices, I believe that risk is again muted -- Weight Watchers' private equity owners also want full value for their shares.
The bottom line
What's healthy for Weight Watchers' customers can be healthy for your portfolio. A competitively advantaged business in a growing market can be had as if it's in decline. I think the market's due to add some meat to these shares' bones.
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