Why I'm Buying Weight Watchers, Again

Dilbert writer Scott Adams summed up timing aptly: "If someone wrote the best hip-hop song of all time in the Middle Ages, he had bad timing."

And like the 15th century Jay-Z, my first purchase of Weight Watchers (NYSE: WTW  ) shares was inopportune -- though I still believe my reasons were well-grounded. Weight Watchers shares have been hammered since -- off 20% in three months, as the market continued its march skyward -- amid an admittedly horrendous quarterly result and guidance, the longtime CEO's "resignation," and what I believe are misplaced concerns over competition from free calorie-counting apps.

These aren't halcyon days at Weight Watchers, I'll admit. But here, I believe, lies our opportunity. Concerns over competition from comparatively simplistic turnkey solutions misses the bigger picture and Weight Watchers' part in it. Losing weight isn't as easy as flipping a switch. It's easy to lie to yourself, persist in bad habits, or let unwitting ignorance pilot the ship. Well-intended efforts are sabotaged. Good intentions, on their own, aren't good enough.

A concrete process and quantifiable benchmarks are better. Its clinically proven approach, network of meetings and online tools, and step-by-step system make me believe Weight Watchers' relevance -- and cash-generating capacity -- isn't in decline. That also why, at eight times my estimate of this year's free cash flow, I'm again buying shares of Weight Watchers for my Real Money Portfolio.

The psychology of success
Why do I believe Weight Watchers can work? Psychology. A recent Atlantic Monthly article detailed a not-so-shocking phenomenon: People lie. A lot. To be exact, 1.65 times per day. I'm altogether not certain how six-tenths mistruths are told, but what's more interesting is how we lie. In disjointed or impersonal forms of communication -- social media or text messages, for example -- mistruths' prevalence is greater. One in 10 text messages contained a fabrication, large or small.

People lie less frequently where accountability seems greater -- email, old-fashioned letters, and so on. The shoot-from-the-hip logic, though somewhat flawed, is apparent. These documents live in infamy, and it can be painful to stare inconvenient realities in the face.

This, in a nutshell, captures why -- for many folks -- calorie-counting apps, limited-scope solutions, and faddish diets don't work. It's easy to fudge your calorie counts on an app, eat the wrong things, and if you don't like what it's telling you, simply delete it. It's also easy, in the absence of a defined plan and series of habits, to fall off the wagon.

It also explains why, in the long-run, I don't think Weight Watchers' will become less significant. Members are afforded access to a clinically proven set of tools. They can attend meetings, led by successful program participants, where support and accountability are on tap. They've a set of online tools, which offer a harder form of reality than a simple app, and dietary tracking mechanisms. As Charles Duhigg's The Power of Habit elucidated in excruciating detail, those organizations and people who most successfully institutionalize habit changes don't do it by accident. They systematize processes.

Weight Watchers does that, and has for more than 50 years.

A company falling off the wagon?
But for the apparently obvious logic, Weight Watchers hasn't been a roaring success recently. Management's current-year guidance calls for more than double-digit year-over-year declines in its core meetings business, and despite runaway growth of recent years, for its online business to sharply slow. The current year's marketing plans haven't resonated with would-be customers. Its meeting leaders have loudly complained of poor pay.

Amid the dust-up, the board moved to replace longtime CEO David Kirchhoff with recently minted James Chambers, who was just named COO in January. While the turnaround isn't likely to follow a linear path, I believe the odds favor Weight Watchers turning out a successful investment, for three reasons: the potential for organizational changes, still large market potential, and a very cheap stock.

Organizational changes: As detailed above, I don't think Weight Watchers' problems are the program itself -- they're about resonating with prospective customers, and making their tools successful. The most recent product roll-outs have been a flop, in part the consequence of poor marketing, and in part the tools' less-than-intuitive feel. With Chambers' appointment to CEO, I believe that's poised to change.

Chambers brings a necessary touchy-feely element to Weight Watchers' upper ranks -- a consumer-products background. Having worked at Kraft, Nabisco, and Cadbury, he (ostensibly) understands the importance of connecting with customers on some fundamental level and spending marketing dollars wisely, which recent marketing campaigns haven't. That can change, and I expect it will.

Likewise, recognizing its leaders' dissatisfaction with current compensation schemes, management's moving to change things. As someone experienced in managing dispersed field organizations, I expect Chambers will set to work reinvigorating and engaging Weight Watchers' most important employees: its meeting leaders. While that's likely to dent earnings in the near-term, it should benefit the long-term.

A huge market: For better or worse, Weight Watchers' market opportunity isn't declining. The CDC estimated that 35.9% of U.S. adults were obese in the 2009-2010 period, and 69% overweight or obese. Currently, Weight Watchers owns less than $2 billion of an estimated $60 billion market opportunity. Weight Watchers probably won't capture an outsize share of the market, but it doesn't need to.

With the CDC's recent decision to classify obsesity as a disease, Weight Watchers might gain a huge captive market by partnering with insurers, as a preventive care option. Likewise, there's a lot of cash on the table in the B2B segment, where employers should be eager to partner with Weight Watchers for the same reasons, and in the process, reduce the bottom-line burden from health care costs. Though Weight Watchers faces competition from the likes of Herbalife and Nutrisystem and smaller upstarts, it seems there's plenty of love to go around.

A cheap stock: As it stands, Weight Watchers shares trade at eight times my estimate of this year's free cash flow. That presumes a company in perpetual decline. As I've detailed, I don't think that's the case. Consider a few figures.

As I noted in my original write-up, Weight Watchers has systematically purchased its franchise operations and brought them in-house. It would spent $778 million at last years' close. By that math, these franchise operations are worth three times the amount paid, $2.1 billion, even if operating income declines somewhere between 3% and 50% (depending on geography). At today's prices, that means we're getting the online segment, which generated half of operating profits, for nothing.

Also of note, Weight Watchers gorged on debt to finance a horribly timed share repurchase last year, going into hock to the tune of $1.6 billion. But there's a silver lining in this: Weight Watchers is, effectively, a publicly traded leveraged buyout. Even if the company's results tread water, management can create value for shareholders by using its still-copious free cash flow to pay down debt. To wit: I expect the company to generate 25% operating margins this year.

While my original assumptions seem a bit ambitious, in retrospect, Weight Watchers' shares still seem meaningfully undervalued. I expect that earnings and margins will take a hit in the coming year, as the company laps installation of its new leader comp plans and lower meeting attendance. But thereafter, I expect the company can grow its revenues at about a 3% to 4% clip annually. Coupled to a healthy dose of debt reduction, I estimate the shares are worth well over $50.

The bottom line
Most times, someone's gain comes at the expense of others' loss. But in the case of Weight Watchers, a happy convergence occurs: Lost weight can, and should, result in share price appreciation. That's why I'm buying today.

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