Weight Watchers International (NYSE: WTW) represents a rare opportunity to short a levered consumer-driven business that still trades at substantial growth multiples amid a highly predictable,  but underappreciated, decline in its growth drivers.  As opportunities for WTW to inflate attendance through acquisitions and boost pricing through a shift in membership plans become saturated, the Company's declining membership will begin to generate stagnant operating results.  In addition, WTW's recent reliance on squeezing pricing from members and high financial leverage leave it particularly vulnerable to topline decline in a consumer-lead recession. Supplemented by tough competition and emerging medical alternatives in the weight management market, WTW has multiple independant catalysts to usher in its decline.     

 

WTW is the world’s largest provider of weight management products and services. The Company derived approximately 84% of its Q1 2008 revenues from its weight management meetings (meeting fees and products sold at meetings) with additional revenues provided by subscription fees to its online weight management site and publishing and licensing of its brand to food companies and restaurants.   The Company’s weight management programs are marketed throughout North America, the UK, Continental Europe and Asia.  In Q1 2008, approximately 61% of meeting revenues were derived from North America.

 

Established more than 30 years ago, WTW has had a volatile record of performance common in the finicky weight management industry.  However, the company has achieved 20% annual revenue and 22% EPS growth over the last two years, predominantly as a result of the Company’s launch of its Monthly Pass (MP) program in Q3 2006.  Previously, substantially all members attended meetings on a “pay-as-you-go”(PAYGO) basis, paying a one-time $25 initial fee and $12-13 per each meeting attended.  In contrast, the Company’s MP offering provides members with unlimited access to meetings and to WTW’s online site for a flat monthly fee of $40 – approximately a 20% “discount” to PAYGO based on weekly meeting attendance.  MP fees are billed until cancelled as a recurring credit card charge. 

 

Since it was introduced, conversion of members to the MP program has been the primary driver of growth in WTW’s pricing metric – average meeting fees per attendance – which grew nearly 24% (from $14.34 to $17.83) in North America in 2007, the strongest growth in the Company’s history.  WTW has achieved this in spite of the nominal discounting of meeting fees under the MP program, due to the “dirty little secret” that the average WTW member actually attends only slightly more than half the recommended weekly meetings (1.8x per month for MP members and 3.0x per month for PAYGO members according to management[1]).  Basically, the MP program inflates the cost of the program 60-65% by making members pay for the meetings they don’t attend and then rebates 20% of this price increase as a “discount”.  This one-time pricing bump from conversion accounts for virtually all the North American pricing (per attendance) growth in recent quarters[2].  Conversely, pricing improvement in international markets remained subdued until the Company introduced the MP program in Europe in Q4 2007.

 

By contrast, WTW’s other meeting revenue driver – attendance growth – has been slowing in North America (to 5.7% in 2006 and 7.8% in 2007) and negative in international markets (-6.2% and –4.8%, respectively) with membership fall-off primarily in the UK and Germany (its two largest non-NA markets).  Moreover, as discussed below, substantially all of the NA attendance growth has been “bought” – obtained through the acquisition of WTW franchises.  Absent these acquisitions, NA meeting attendance grew by only 2.9% in 2006 and actually declined 1.7% in 2007.  This gradual erosion in attendance came to a head in Q1 2008 when attendance levels declines in all of WTW’s markets – North America (-5.4%), the UK (-8.1%), Continental Europe (-6.3%) and ROW (-20%).    Last quarter was particularly disastrous in Germany, where after 8 quarters of significant membership declines, attendance declined “double digits” despite the introduction of substantial product changes in the UK and Germany in Q4.   Despite an ostensibly easy scapegoat, management insists that declining attendance is unrelated to consumer weakness and due instead to the “lack of substantial product innovation” over the last 4 years (i.e., since reformation of the program in response to Atkins).  However, management’s guidance regarding introduce a new plan concept (initially in North America) has consistently been relegated to the distant future – currently Q1 2009 – without any explanation as to why required lead time is so long and without any vague notion of what this all-important program innovation will involve.  Nevertheless, with revenue and earnings growth still positive, the Street appears willing – momentarily – to suspend disbelief toward this extremely suspicious strategic black hole.

 

Consequently, in response to consolidated revenues and EPS growth of 9.4% and 14.3% -- the slowest rates in 10 quarters -- WTW shares declined only 7% following Q1 results.  However, as discussed below, this deceleration is far from over as WTW faces the near-term loss of its two principal drivers of top-line growth in an environment likely to prove especially challenging for weight management companies.  Given the absence of a new product strategy, low operating leverage / cost cutting opportunities and substantial indebtedness, we believe the shares are likely to decline substantially further as attendance declines begin to impede revenue and earnings growth.

 

#1.  Unsustainable franchise acquisitions in North America have obscured real declines in attendance, suggesting that organic customer acquisition is becoming more difficult and costly and/or that the WTW concept is losing steam in mature markets

 

Over the last seven quarters, WTW spent over $170 million to acquire a large portion of its franchisees, predominantly in North America.  Doing so has allowed the Company to count attendance at acquired meeting sites as “growth” as well as book additional revenue (100% of meeting fees rather than 10% royalties, retail versus wholesale product margins).

 

 

Not only is this “growth strategy” inherently limited as there are a dwindling number of franchises to be acquired (franchised attendance as a percentage of total attendance fell from 25% in 2006 to 18% in 2007), but, in addition, acquisitions to date have been grossly value destroying. In fact, based on the estimated average acquisition cost per member in Q3 2006 – Q3 2007 (in North America, *figures based on estimates provided by management), WTW has lost approximately $912 on every member acquired through such consolidation:

 

Quarterly incremental attendance from acquired franchises Q3 YOY (per filings): 900k

Average attendance per member per month: 2.4x*

Estimated acquired members: 125k

Total acquisition costs (5 NA acquisitions, per filings): $153.3mm

Working capital acquired: $5.5mm

Total member acquisition costs:  $147.8mm

Cost per Acquired member: $1,182

Monthly fee revenues per MP member[3]:  $40

Estimated product purchases per member per month: $12

Total meeting member revenues per month: $52

Gross margin (blended offline per filings): 65.1%

Monthly GM contribution per MP member: $33.8

 

 

Because management has pursued this “growth at any cost” strategy aggressively since 2001 ( in total, the Company has acquired 15 franchisees for a total $600 million), it has few franchisees in North America of any scale left to acquire.

 

 

As noted above, conversion of current customers to the MP program accounted for nearly all organic growth in North American revenues over the past two years.  Specifically, looking at 2002-2006, pricing in North America was relatively flat prior to 2005 as the Company focused on emergence as a public company and dealing with attrition from the low-carb/ Atkins diet fad but, even in the buoyant growth environment of 2005-2006, pricing growth remained 7-8% per annum.  Note that this was under a PAYGO pricing model in which customers only experience pricing increases a week at a time (e.g., from $12 to $13) while one would expect pricing increases to occasion greater “sticker shock” under a monthly billing program.  Nevertheless, as described above, one-time conversion to the MP program allowed the Company to effectively increase average per-attendance pricing by 23% in 2007.  Since its launch, the Company has never attempted to increase the MP program fee. 

 

A curious (and somewhat suspicious) long-term theme of the Company’s reporting is the scant regular publication of operating metrics – particularly, membership, and more recently the number of members on the MP program.  To date the only operating metrics that the company regularly reports and breaks out geographically are “attendance” and, beginning in late 2007 in North America, “Paid Weeks”[4].  Prior to the launch of the MP program in 2006, management justified this lack of transparency by asserting that the PAYGO model did not yield a definable membership base because participant attendance at meetings was too irregular.  Whatever one thinks of this rationale during the Company’s PAYGO past, it clearly lacks merit under the current model where MP program membership is clearly known (on a real-time basis) and continuing PAYGO participants are aggressively tracked by the Company in order to convert them.  In response to repeated analyst inquiries, management began in Q4 to orally disclose the share of attendance represented by MP members on quarterly earnings calls – the result: after four quarters of double-digit sequential growth in 2007, MP share of attendance in Q1 2008 increased by only 3% (from 50% to 53%).  Based on the significantly lower attendance frequency of MP members relative to PAYGO members, this equates to approximately two-thirds (66%) MP penetration of the NA member base – a very high share if you consider the significant population subsets that could/would never convert to the program – members without credit cards, without computers/computer literacy (registration is online), the financially ultra-conservative (would not sign up for recurring credit card billing) and, most importantly, those “just trying it out” (remember the average PAYGO tenure is only 10-11 meetings and this distribution likely has “fat” tails.   Not surprisingly, in explaining decelerated revenue growth in Q1 (6% year-over-year excluding currency gains), management noted that annual lapping on accelerated MP adoption in North America in Q4 2006 and Q1 2007 would render this growth driver “limited” on a go-forward basis.  More simply stated, conversions to the MP program in North America are hitting a saturation wall.

 

Moreover, the pricing gains achieved by WTW through strong adoption of the MP plan are likely to be undone if consumers reevaluate their budgets in a recessionary environment.  While none of the other large commercial weight-loss companies (e.g., Nutrisystem, Jenny Craig, Zone Labs, LA Weight Loss) has been publicly traded through an entire business cycle, participants (including WTW) generally acknowledge that the industry is highly sensitive to declines in consumer spending.  Bluntly stated, customers look for reasons to give up on diets and few reasons are better than fiscal discipline.  While not a large household budget item, the $40 regular monthly membership is conspicuous upon review of a consumer’s credit card statement, and recurring credit card billing (“RCCB”) will automatically be disrupted if consumers cancel their credit cards.  More importantly, WTW members need not exit the program for WTW to be seriously harmed by dampened consumer spending.  They simply need to act on the fact that the program is uneconomical in light of their actual attendance and switch back to PAYGO.  Doing so would save customers nearly 60% on the cost of attending meetings (at their actual 1.8x/mnth attendance rate).  Alternatively, members utilizing WTW Online’s tools could enjoy substantial savings (25%) by forgoing meetings and joining the online offering for $30/month. 

 

Indeed, the one bright spot in WTW’s Q1 results was a 30% YOY membership increase in WTW Online – a reacceleration from growth in 2007 quarters of 20-25%.  Note, however, that despite this accelerated growth, at only 10% of total 2007 revenues and margins only slightly higher than meeting fees after accounting for the lack of associated product sales, online revenues are an insufficient to compensate for declines in physical attendance.  To some extent this growth reflected the introduction of WTW Online in European markets in Q4 2007 but adoption in North America reaccelerated as well.  Management credits this to increased marketing spend which rose dramatically in Q1 but did so in equal measure for online and meeting-based products.  However, the more likely/encompassing reason is that these members are being converted at an increasing rate from meeting membership and, in particular, the MP program to online membership.  With the average MP member attending with a frequency of less that once every two weeks and many with relationships now much more firmly rooted in the use of WTW’s online tools (e.g., meal diaries, “points” calculators) than its traditional meeting culture, growth in online membership at the expense of meeting attendance comports best with declines in North American membership.  Most telling, in response to queries about this potential offline-online conversion, management’s response is unsurprisingly that it can not track such member activity – an implausible justification given that both programs require credit card use and detailed member information.

Turning to the one remaining near-term growth driver, in response to queries on the Company’s year-end earnings call about the effectiveness of the launch of the MP program in Europe, management glibly stated that it was below penetration seen in the U.S. but “inline” with (undisclosed) internal expectations.  Poor adoption of the MP program in Europe is not altogether surprising given (i) the generally inferior attendance patterns in Europe and (ii) the fact that RCCB programs are far less common in most European countries relative to the United States (save potentially the UK).  While no hard statistics are available, a retail payments expert we consulted cited the more recent proliferation of credit card issuance and higher usage of debit (versus credit) cards (required disclosures for debit card billing are more stringent) in Europe as likely reasons for the lower prevalence of RCCB programs.  Regardless of the reason, WTW is in far less charted waters getting its European customers to sign up for an opt-out billing process tied to their credit cards.  Not surprisingly, management was conspicuously reticent towards discussion of MP adoption in Europe, noting it was still in its early phases (despite the fact that the strongest U.S. adoption of the program occurred in the first two quarters following it launch).   

 

 

While more prevalent in Europe, a steady stream of new diet drugs has recently begun to launch in the US that should grow considerably over the next five years in both breadth and direct-to-consumer (“DTC”) spending.  Weight loss pharmaceuticals largely fell out of favor following the withdrawal of Fen Phen from the market in 1997.  Consequently, the early and mid-2000s were marked by a lack of new drug entrants with the most popular diet pills, Xenical (a prescription orlistat/fat blocker marketed by Roche) and Meridia (a SNRI/CNS-focused drug marketed by Merck), approved in the late 1990s.  By contrast, 2007 saw both the launch of the first FDA-approved OTC diet pill, Alli (essentially a low-dose version of Xenical), and significant clinical progress on at least eight prescription drugs in development. 

 

 

In June 2007, GSK launched Alli to considerable initial adoption in the US, and by mid-October, the Company announced it had already sold more than 2 million 60-day starter kits.  Armed with an FDA-approved claim of “50% more weight loss”, Alli’s approval was conditioned on marketing in conjunction with a drug-company sponsored holistic weight loss plan that directly competes with commercial plans.  Importantly, a steady stream of new diet drugs, all with companion weight loss plans both as a means of customer retention and due to the FDA’s predisposition for holistic treatment offerings, promises to be highly disruptive to weight loss centers as dieters abandon programs to try new fad drugs, regardless of whether or not they ultimately prove successful. 

 

#4.  Debt Covenant Issues in a “Downside Case

 

Coaxed by its former private equity sponsor and current majority shareholder, the Artal Group, the Company in January 2007 completed a debt-financed $1.025 billion Dutch tender offer to repurchase shares (repurchasing 19 million shares, 19% of total shares)[5].  As a result of the transaction, WTW’s total debt ballooned from $830 million to $1.8 billion.

 

Under a Downside Case scenario in which WTW faced reverse-conversion of members back to PAYGO, our projections indicate that WTW would face financial covenant issues under its recently expanded credit facility.  Specifically, the Company would modestly breach both net leverage (5.1x versus 5.0x) and interest coverage (3.05x versus 3.0x) by Q2 2008.  More importantly, the Company would be cash flow (levered) breakeven in 2009+.  Lenders would, at a minimum, force the Company to cancel the dividend ($50 million per year). However, even without the dividend, free cash flow would be insufficient to service debt amortization beginning in 2009 (when the Company’s expanded Term A loan begins to amortize).  With 2009 net leverage likely to exceed 6x (projected 8.1x), and negligible hard asset coverage, lenders could likely require more draconian action to facilitate prepayment (e.g., increased franchising, sale, equity raise) in the event of a covenant violation.  While the Company admittedly has substantial room currently under these covenants (current leverage is only 3.6x), performance erosion could be particularly rapid and dramatic in the face of such “reverse conversion”.  For example, if only 50% of current MP members opted to convert to WTW Online membership (approximately the same portion of members that originally converted to the MP program in its first two quarters after launch), the resulting 7% decline in NA net revenues (25% decline in subscription fees), combined with the mid-single digit loss in attendance guided to by management and the loss of associated product revenues (most of which are purchased at meetings) would yield a total NA revenue decline of approximately 11% with a gross margin impact (at 2007 levels) of approximately $48mm or 11% of consolidated EBITDA.  With Conversion of some MP members back to a PAYGO model (with the associated higher unit revenue decline), sharper declines in attendance due to weak consumer spending and weight loss alternatives and continued international weakness, such a downside case is not outside the realm of possibility.  Moreover, given the nature of WTW’s business (low fixed costs, meeting leader driven, outsourced product manufacturing), the Company has few cost cutting levers to pull in response to such top-line erosion.

 

#5.  Valuation

 

Despite significant weakening in consumer spending, WTW shares were down only 26% from their 52-week high.  In addition, there remains some concern that Artal Group could sell shares to reduce its exposure following what remains a 10x return based merely on its liquidations to date in an investment that is now 9 years old.

 

As of the end of April, WTW’s market enterprise value is 15.4x 2008 consensus EPS of $2.90 and 10.6x 2008 EBITDA of $487 million.  This is at the low-end of WTW’s historical valuation ranges, which have run from 15-28x and 10-20x forward (NTM) earnings and EBITDA, respectively, since the Company went public.  However, the Company has never before been in a position when its global attendance evidenced a consistent long-run pattern of stagnant/declining growth at the same time it appears to be running out of levers to increase pricing.  Even during the height of the low-carb / Atkins craze, WTW enjoyed strong growth in its international meetings and could point to a dominant online offering that was growing at triple-digit rates.  With limited growth prospects in the absence of strong MP conversion in Europe, WTW is a highly levered, low growth business with minimal operating leverage in a highly competitive, consumer-driven market. 

 

As such and given its leverage, WTW is most appropriately valued on an EBITDA basis and should trade at a 6-8x valuation in the absence of real growth prospects.  Nutrisystem, its only public comparable, while admittedly an inferior company, trades at 5.2x NTM EBITDA.    Recently, the Company announced a 51/49 JV with Group Danon to launch a to-be-defined weight loss offering in China.  While visibility into the operation is probably several years away, its headline value and continued subscriber strength at WTW Online may be enough for WTW to retain the low-end of its historical value range (10x EBITDA).  Conservatively applying this to our Base Case (e.g., no reverse conversion, mid-single digit NA attendance declines) 2008 EBITDA of $443mm yields a price per share of $35.  A probability-weighted DCF analysis of this, an Upside Case (modest attendance recovery and pricing from resurgent MP penetration; current valuation multiple) and the aforementioned downside case yields a price per share of $31 (30% downside).

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