In a volatile market, investors should beware of beaten-down stocks that are being promoted as "contrarian" buys. Some of these companies are built on broken business models, so their chance of recovering -- even in a fierce bull market -- seems unlikely. Let's take a look at two such stocks which fit that description: GNC Holdings (NYSE:GNC) and Weight Watchers International (NYSE:WTW).
What's wrong with GNC Holdings?
Shares of nutritional supplements retailer GNC have plunged nearly 40% over the past 12 months because of tepid sales growth, numerous probes and lawsuits across the U.S. regarding its herbal supplements, and concerns about bigger competitors rendering its stores obsolete.
Last October, the Oregon Attorney General claimed that certain GNC supplements contained "potentially dangerous ingredients." Shortly afterwards, the U.S. Department of Justice indicted executives of USPlabs, which sells its supplements at GNC stores, for adding toxic substances to its products.
Meanwhile, third-party vitamin and supplement brands sold at supermarkets, pharmacies, wholesale, or online retailers have hurt GNC's sales and its strategy of attracting return customers with membership programs.
Last quarter, GNC's sales rose 1.8% annually to $618.2 million, but that missed estimates by about $3 million -- marking its fourth consecutive top-line miss. Adjusted net income fell 7.6% to $49.9 million, but adjusted earnings (inflated by buybacks) rose 3.3% to $0.63, beating estimates by a penny. Analysts expect GNC's sales growth to remain between 1% to 2% over the next two years, but earnings are expected to grow 10% annually over the next five years. That forecast gives GNC a five-year PEG ratio of 0.9, which looks undervalued compared to its earnings growth potential.
But the problem is that GNC's earnings growth is fueled by buybacks, which gobbled up 155% of its free cash flow over the past 12 months. This means that its buybacks are being financed by debt, which will become a pricey strategy once interest rates rise. On the top line, GNC is also inflating its sales growth with new store openings -- that's why its 1.8% sales growth outpaced its 0.8% comps growth last quarter. These figures suggest that GNC is already skating on thin ice, and additional legal troubles, higher interest rates, and the threat of bigger retailers undercutting its prices raise serious questions about GNC's future.
What's wrong with Weight Watchers?
Weight Watchers has fared better than GNC over the past 12 months with a 35% gain, but the stock has also plummeted nearly 40% this year because of rising competition and the rise of fitness trackers, free health and diet tracking apps.
Those pressures caused its sales to fall 21% annually last quarter to $259.2 million, which nonetheless beat expectations by $1.5 million. Weight Watchers' quarterly revenue hasn't risen annually since the fourth quarter of 2012, and sales have fallen over 20% for the past four quarters. On the bottom line, Weight Watchers posted a net loss of $11.3 million last quarter, compared to a profit of $4.4 million a year earlier. That translated to an adjusted loss of $0.03 per share, which missed expectations by five cents. Looking ahead, analysts expect Weight Watchers' earnings to fall at an average rate of 0.7% annually over the next five years.
Those numbers look bleak, but Weight Watchers believes that the support of Oprah Winfrey, who joined as a director last October and bought a 10% stake in the company, can rekindle customer and investor interest. The so-called "Oprah Effect" boosted the stock to a 52-week high of $28 the following month, but those gains proved unsustainable. In late January, Winfrey released a video claiming that she had lost 26 pounds on the new Weight Watchers program, which sparked another short-lived rally.
The following month, Weight Watchers stock spiked again after a study by Indiana University medical school researchers claimed that adults with pre-diabetes lost "significantly" more weight and exhibited improvement in pre-diabetes markers compared with those who tried to lose weight on their own. However, the subsequent revelation that Weight Watchers itself funded the study raised concerns that the company was trying to juice up its stock price again. The company's recent history is one of hype-fueled short-term stock price growth, not one of an improving its underlying business.
But evaluate the bull case as well
I believe that GNC and Weight Watchers are weak investments, but investors should also understand the bull cases for both stocks. GNC bulls believe that the company's stand-alone store comps growth, valuations, and ability to withstand legal challenges make it a sound investment. Weight Watchers bulls believe that new apps and Oprah's massive fan base will drive more visitors to its website and translate into new subscribers. Therefore, investors should do their due diligence to decide if GNC and Weight Watchers will sink or swim this year.
Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.