Weighing In With Weight Watchers

 | Mar 07, 2014 | 5:00 PM EST
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In a rather neutral market so far this year, big stock price moves garner attention -- and not all of it is welcome. For value-oriented investors, a major price decline is frequently a trigger to look more closely and try to determine if the selloff is an opportunity or a trap. The 35% year-to-date price drop in the case of Weight Watchers (WTW) caught our attention.

Weight Watchers is the iconic weight management business, operating in many countries worldwide through company-owned and franchised locations. The company serves a large and growing population of the overweight and obese, and the efficacy of its program has been proven in a plethora of peer-reviewed studies. It has had a long track record of success by its members, who pay monthly to attend meetings where motivation, ideas and counselling are dispensed privately as well as in a group setting -- along with sales of food and ancillary products. In response to free competitive offerings, Weight Watchers has also created online interactive trackers and tools that also come at a cost. This price disadvantage has severely impaired the growth in new Weight Watcher subscriptions, especially among casual users.

WTW started the year at $33 and moved down with the market prior to its year-end earnings release in mid-February. Earnings were a major miss, and forward guidance for 2014 was even worse. The stock was down 27% the next morning, and has trended down since. The company's winter marketing campaign, critical for attracting the New Year's "resolutionists," has not been well-received by consumers, putting a lid on its growth prospects for the entire year.

But the company is not standing still. A new CEO, James Chambers, was elevated last July after coming on earlier in 2013 from a successful career in a variety of consumer and food companies. In turn, he installed a new president of North America with strong marketing credentials and a new chief technology officer, both of whom are just now gaining traction for their turnaround initiatives. An aggressive overhead cost reduction plan already in place is showing results, and it will eventually amount to $150 million by the end of 2015.

A key aspect of the investment is Weight Watchers' capital structure. On the negative side, the balance sheet is highly leveraged, with $2.2 billion in net debt and negative net worth. Fortunately, the company should generate about $140 million in free cash flow -- even at this depressed level of earnings. No debt is due until a $300 million payment in April 2016, the company has access to a $250 million credit line, and there are no covenants on the debt.

On the plus side, 52% of the company is owned by the private equity shop that bought WTW from Heinz in 1999. It's been a superior investment for them, and their majority ownership is an indicator of their continued positive long-term outlook for the investment.

Much of the operational upside potential for Weight Watchers is derived from three initiatives: 1) tight expense control while continuing to invest in strategic marketing programs, helping to maintain good free cash flow, 2) responding to the on-line competition with a comprehensive offering building on its successful legacy meetings supplemented with improved digital tools and, most importantly, 3) developing an offering that can be co-marketed with health plans perhaps as early as later this year. The last effort could be a game-changer for WTW's member count, if companies and their insurers incentivize employees to lose excess weight.

To be clear, an investment in Weight Watchers is a speculation. But we believe it is likely a good one, driven by the best brand in weight management and the global need to address a large and receptive target population. The valuation is attractive, even based on the very depressed 2014 earnings consensus, and it's dirt cheap based on normalized earnings power. The risk from the high debt level is not imminent, but could grow if the turnaround doesn't begin to take hold over the next few years.

Three months ago, earnings expectations for this year were nearly $3 per share; they are now at $1.40. If the programs started by new management stabilize member trends, then earnings power can be restored, and the financial stress will evaporate. It's easy to see how the stock could be up 50% or more in a year's time if just some of the company's plans garner success.

Any reputable weight management program requires a long-term commitment; it takes time to get results that slowly but steadily accumulate. An investment in Weight Watchers could follow that same kind of path.

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