Description

Recommendation: Buy

Stock Price: $41.73

Price Target: $53 (27% upside)

Upside: $65 (56%)

Downside: $37 (-10%) 

Market Cap: $2.3B

Enterprise Value: $4.6B

FCF Yield(2012): 11.2%

FCF Yield (2013E): 9.8%

PE (2012): 9.1x

PE (2013; midpoint of guidance): 11.2x

EV/EBITDA (2012): 8.5x

EV/EBITDA (2013E): 9.1x

Dividend Yield (Ordinary Dividends only): 2%

Description/Thesis:

Weight Watchers (WTW) is a high margin, cash generative business with a loyal core customer base (current and repeat members) which I think is being over-penalized for short term issues with recruiting new members (“never-members”) which caused them to provide weak guidance for 2013.  These issues have given investors the opportunity to buy a high-quality business at an attractive 11% FCF yield (on 2012; 9.5-10% on 2013E) near its 52 week low, while the rest of the market continues to rise.      

Revenues are comprised 52% by Meeting Fees, 21% by Product Sales, and 28% by Online Revenue, with online growing rapidly the past few years, from 196M in 2009 to 504M in 2012.  Operating margins have been high and fairly stable, being between 25.5% and 30.7% (27.9% in 2012) the past 9 years.  While 2013 is expected to be at the low end of this range (as GM contracts ~200-300bps) I expect in 2014+ for margins to stabilize.  WTW generated $262M (271M if add-back stock comp expense) in FCF in 2012 and has averaged $258M in FCF the past 9 years.  The company has reduced the share count from 110M in 2003 to <56M today (the $3.3B in repurchases in that time is higher than the current market cap).  While the $1.5B in repurchases (Tender Offer) in Q1 2012 at $82 was less than ideal for remaining shareholders, management has shown the willingness to repurchase shares.  (Artal Group owns 51.6% of shares (Artal Group is fund of Invus Group run by Ray Debbane, who is Chairman of WTW) and sold part of there stake in the tender offer at $82 although they maintained the same % of the shares as before and should continue to maximize shareholder value.)

WTW recently gave weak 2013 guidance on Feb 13: $3.50-4.00 in eps, low single-digit revenue declines (caused by High-Single-Digit to Low-Double-Digit Declines in Global Meetings Business and Flat to Slightly Positive Online Business), and 200-300bps decline in Gross margins.  Additionally, WTW debt was recently downgraded by S&P from BB to BB-.  The market is treating WTW like it’s a weak company in terminal decline, with the stock down 50% in the past year and 30% in the past 2 months. 

I believe the market is over-penalizing WTW for mainly Short Term issues.  WTW is highly seasonal in adding new members (“never-members”), with January being the key month for people to start new diet plans (with Weight Watchers having the most paid members).  As a result Q1 revenues are generally ~25% higher than Q4, with revenues declining in between as some of the new members cancel over time. This January WTW had several different issues occur which caused new member additions to be weak (and which then has a large effect on the rest of the year).  First, Taxes went up to start the year on everyone in the form of the payroll tax.  This 2% increase decreased paychecks on $50K households by $75 per month.  With many household budgets already strained, starting a new WW plan for ~$20-$40 was likely of lower importance than normal (at least in the 1^st month or two of the year).  Additionally, they had signed Jessica Simpson as a new spokesperson in summer 2012.  After losing 50 pounds on WTW over the next 6 months she announced in December that she was pregnant and thus not an ideal spokesperson going forward to talk about weight loss, and WTW had to scramble to modify their ads.  Additionally, their new Weightwatchers 360 plan had positive reception from current members, but their messaging surrounding it was weak/unclear and failed to resonate and attract new members as strongly as desired.  I think these issues can be overcome, somewhat in 2013 (consumer confidence trended up in February (most correlated factor to new recruitment)), and more pronounced in early 2014.     

The long term trends in the global weight management market are strong, currently consisting of ~75M dieters spending $62B in 2011 in the US alone.  “The number of overweight and obese people has steadily increased around the world over the past 20 years and is estimated to reach approximately 3.0 billion by 2015, primarily driven by changing eating patterns and increasingly sedentary lifestyles. Between 2007 and 2008, 68% of Americans over the age of 19 were considered overweight and almost half of these were obese. Numerous diseases, including heart disease, high blood pressure and Type II diabetes, are associated with being overweight or obese.”  Healthcare costs for obese people average ~$1400/year more and for people with diabetes are ~$6600/year more.  These increased costs should drive increased usage of plans such as Weight Watchers either directly by individuals, or subsidized by health care plans.  Weight Watchers is the most well-known plan and many studies have been done on it and have shown it to be effective so it should benefit from these trends.

The biggest concern I have with WTW is regarding competition from the free weight loss apps.  In the latest call the company mentioned increased competition from free apps as being a cause of their slowed WW.com growth the past 6 months.  MyFitnessPal seems to be the biggest threat of the free apps, as it has now had over 10M downloads, and is a good app for keeping track of your eating/exercise.  The company believes that most people download and use these a couple times and then stop using them (although hard to verify usage).  And according to the Journal of Internal Medicine (and WTW internal research) what drives positive weight loss outcomes with Apps and Online offerings is when they are combined with human face-to-face interaction.  The WTW monthly plan combines online with a large network of in-person meetings, while the apps such as MyFitnessPal do not.  WTW believes many people may be trying these free apps, but will ultimately be unsuccessful losing weight on them, and will eventually use WTW instead.  I’m not 100% convinced of this, especially when the free apps are combined with users social networks such as Facebook and Twitter, but there should be enough room for both paid and free options, and at current prices you don’t need much growth in WW.com to support a higher stock price.             

Valuation: WW is currently trading at an 11.2% FCF yield on 2012 and ~9.5-10% on 2013E.  Following a decline in 2013 I think Rev/Eps/FCF will increase again in 2014 from a better winter selling season (better advertising campaign/messaging, non-pregnant spokesperson, and no payroll tax increase).  I think WTW is worth 12-14x 2014E FCF of $250-260M = $53-65/share (with a downside of ~$37).

Business Summary:

Pretty much everyone is familiar with Weight Watchers.  It is the leading commercial weight loss program in the world, founded 50 Year Ago by Jean Nidetch, who initially arranged meetings of friends desiring to lose weight to share dieting ideas (including what she learned attending an obesity clinic) and provide support to each other.  In 1978 Heinz acquired Weight Watchers and owned it until 1999, when Artal Luxembourg (Artal Group) purchase it from Heinz (which maintained a perpetual royalty-free license to sell Weight Watchers brand food (with points values listed)) in an LBO for $735M (including only $224M of equity).  Artal Group brought it public in 2001 and currently owns 51.6%.   

The program is based on a proprietary points system (PointsPlus) where each food is assigned a number of points, and the diet is limited to a total number of points per day/week.  WTW sells its own co-branded food in stores/online (with PointsPlus listed) or can eat your own food and calculate the points (or use guides).  The plan promotes eating healthier, maintaining a caloric deficit, and exercising.  WTW had a very strong 2011 driven by a change to the new PointsPlus system (as well as adding Jennifer Hudson as spokesperson), whereby most fruits and vegetables were worth 0 points, to promote eating as many of these healthy foods as they wanted. 

Members take part in the program via in-person meetings and/or an online program.  The meetings are run by a group leader (currently ~10K) who has successfully lost weight in the past on the WTW program and have the added benefit of weigh-ins to monitor progress and positive reinforcement by other members and the leader.  Each week over a million members attend over 40K WTW meetings around the world.  There are also currently 1.9M active Online Subscribers (online/app), up from 1.05M in 2010.  There were 111.5M Online Paid Weeks in 2012 (up from 88M in 2011 and 52.5M in 2010) and 99.2M Meeting Paid Weeks in 2012 (from 104.8M in 2011 and 87.9M in 2010).  Meeting attendance at company owned operations has declined to 50.7M paid weeks in 2012, from 57.0M in 2011 to 51.0M in 2010.  WW.com online membership costs $18.95/month (eTools costs 14.95/month), while a Monthly Pass costs $42.95/month, which includes unlimited in-person meetings and free eTools, and pay-as-you go costs ~$14/meeting. 

Revenue is comprised 28% by online, 51% by meetings, and 21% by products.  They sell a range of products, including bars, snacks, cookbooks, food and restaurant guides with PointsPlus values, Weight Watchers magazines, PointsPlus calculators and, most recently, ActiveLink, an activity monitor and web experience that tracks activity throughout the day.  Franchises represent less than 17% of worldwide attendance and in 2012 had attendance of ~10M people.  Franchises typically pay a fee of 10% of their meeting fee revenue (and is included in the Meeting segment revenue. 

Catalysts:

Hitting high end of conservative 2013 guidance:  WW’s weak 2013 guidance (3.50-4.00 in EPS) was based upon the assumption that weak numbers through the earnings call on 2/13 would continue for the rest of the year.  Consumer confidence (the best macro indicator) is up in February and the initial shock of the payroll tax increase may have abated.        

Return to growth in 2014: Even if 2013 remains weak, it’s likely that the issues that affected January (payroll tax increase, pregnant weight loss spokesperson, weak/unclear advertising with Weightwatchers 360) won’t repeat themselves and they’ll have a much stronger January 2014 adding “never-customers”.

Debt paydown and/or stock repurchases:  WW has generated an average of $258M of FCF (ex stock comp) per year the past 9 years.  While that could be $20-40M less than that this year, that’s still $220-240M in FCF while will be used for debt paydowns and/or repurchases.  The company has repurchased $3.3B of stock the past 9 years using FCF and some additional debt.  They have $209M of repurchase authorization outstanding although they are likely to focus on reducing debt.   

Risks:

Increased competition from apps/online solutions:  The company mentioned increased competition from free apps as being a cause of their slowed WW.com.  MyFitnessPal seems to be the biggest threat of the free apps, as it has now had over 10M downloads. 

Continued decline in in-person meetings:  WW forecasts a high-single to low-double digit decline in attendance (and paid weeks) in the Global Meetings Business for 2013.  I expect this will moderate in 2014, but further significant weakness could undermine the value proposition, as current members get value from the interaction with the other members in attendance.         

Successful (and safe) Obesity Drug:  Qsymia and Belviq were approved last year, the first medicines approved in the US to fight obesity since 1999.  While there were high expectations, Qsymia has underperformed expectation since coming to market in September 2012, with a 22% decline in new prescriptions since peaking on 2/8 due to high patient costs.  Belviq was approved last June by the FDA but hasn’t been approved yet by the DEA (though should be soon), and due to danger of addiction, will be classified as a controlled substance (although in low-risk category).  Qsymia and Belviq are ~$150-200/month versus $43/month for WW.  And insurance coverage isn’t common for Qsymia, with only 1 in 5 prescriptions cover, with an average copay of $50-60.  Additionally, Qsymia is only approved for those with a BMI of 30+ (Obese) or 27+ (overweight) only if also have another weight-related problem such as high blood pressure or high cholesterol.  However, taking it during pregnancy can cause birth defects and other possible side effects are an increased heart rate, suicidal thoughts, and a greater risk of glaucoma.  Many doctors are skeptical that an obesity drug can be produced that doesn’t have negative effects on the cardiovascular system.

Catalyst