Weight Watchers International (NYSE:WTW) released its Q1 FY14 results this week, and I believe there were a number of positives for investors. While I always maintain a long-term view and do not place significant reliance on quarterly earnings announcements (their contents and interpretation by the market frequently tends to be short-term oriented, and focused on simplistic metrics like EPS), it is necessary to consider WTW's latest announcement in the context of its present turnaround situation and my recent 5% portfolio position in its common stock.
In summary, I believe the key takeaways from the 8-K and earnings call are:
- The business is beginning to stabilize, as I believed it would in my investment note (Weight Watchers International - Is The Fat Lady Singing?), with results ahead of previous guidance and consensus estimates; management also indicates that the rate of recent performance deterioration is now slowing
- Although double-digit deterioration occurred in Q1, this was expected as per management's previous guidance
- Management's previous guidance for Q1 given in February was honest and accurate with the Q1 actual results indicating that management had a clear understanding of what the (fixable) problems were in the business and how these impact performance in the near term. Management recognizes where the business has gone wrong in recent times and are addressing this with a clear turnaround plan
- Management continues to articulate an honest assessment of the Company's position and prospects, making it clear that the business still faces significant competitive and operational challenges, but early indications from Q1 results are broadly positive
- These challenges will not be fully overcome in FY14 or perhaps even in FY15, and any potential return to historical performance levels in terms of revenues and free cash flow are unlikely to be achieved before FY16
- Overall, early indications are that the Company is beginning to stabilize, suggesting that management's turnaround plan is working
- There is significant upside for common stock holders should management successfully implement the turnaround plan. On this basis, I may increase my portfolio position in due course
Summary of results:
Q1 FY14 performance can be summarized as follows:
Summary of performance
On initial review, the latest Q1 YoY trends look concerning:
- Overall $82m decrease in Q1 revenue YoY, primarily attributable to challenging North American market - North American revenues declined by $69m, attributable to declines in meetings business ($34m), online ($17m) and other revenues ($18m decline, relating to in meeting products sales and other revenues)
- Decline in North America driven by lower opening subscriber base YoY, and lower recruitment for meetings and online businesses
- Despite launch of Simple Start program, recruitment declined impacted by wearable fitness monitor devices and free apps
- Balance of $13m in overall revenue decline mainly attributable to Other Revenues, comprising licensing, magazines and third-party advertising (declined by $8m) and UK (decline of $7m), offset by $2m increase in Continental Europe (CE) revenues
While these highlights seem quite negative, they were not unexpected, having previously been forecast by management in previous guidance. Additionally, Q1 actual performance was ahead of both previous management guidance and consensus estimates, indicating that management's turnaround plan is working, with the improvement in net income in Q1 achieved by successful cost-cutting initiatives as part of the turnaround strategy.
Notable management commentary from the Q1 earnings conference call includes:
- Recruitment trends, while still negative are no longer getting worse - management seeing signs of stability:
"While recruitment trends remain weak, they are no longer getting worse. As a result revenue is likely to be slightly better than our previous outlook, but nonetheless we still expect it to be roughly $1.4 billion for the full-year." (Nick Hotchkin, CFO)
"During Q1, we saw some signs of stabilisation in our top-line trends as we made some adjustments to our advertising, which had a positive impact on recruitment trends" (Nick Hotchkin, CFO)
- New revamped advertising campaigns helped in North America and UK markets, using celebrity brand ambassador Jessica Simpson in the US and campaigns in the UK emphasizing food and food choice
- Effective marketing and improved recruitment in UK and Continental Europe resulted in better than expected results
- Management continues to present an honest and realistic assessment of WTW's position and prospects:
"We still have a lot of work ahead of us, but I am encouraged by the progress we have made in our transformation plan so far this year. The remainder of 2014 will certainly be challenging as we face a difficult recruitment environment" (James Chambers, CEO)
- Turnaround plan targets $150m of gross annualised cost savings across 2013 and 2014 and business is on track to meet this target
- Paying down debt remains management's capital structure priority
Business operations and strategy highlights:
Management discussed the following business highlights on the Q1 earnings conference call:
- WTW has entered new partnership with advertising agency Wieden Kennedy in US to reposition brand and new product strategy
- Company increased its equity interest in Brazilian partnership to 80% from 45%, gaining control of number one weight management company in Brazil for the last 40 years - Brazil represents an attractive growth opportunity
- Developing new product innovation in response to consumer preference for greater personalization offering - for winter 2015 diet season, WTW will be expanding personalization content using meeting leaders or service providers to deliver tailored one-on-one member interaction
- New CTO Dan Crowe is leading Company's technology investment and enhancement initiative as part of turnaround plan - recognition that Company was slow to adopt new technology capability to meet consumer expectations; stated 12 month horizon to modernize and enhance technology platform, including building a data engine to take advantage of Company's vast data stores (e.g. over 1 billion food items in its database vs. MFP's 3 million food types categorized). The Company is working to move beyond its existing mid-2000's legacy technology platform, with the aim of being a digital hub of weight loss, health and fitness ecosystem, via a service-oriented, data-driven, cloud-enabled model. The upshot of new technology platform is that new products can be rolled out more efficiently, over a shorter time frame, in months rather than a year.
- In April, WTW acquired Wello, a San Francisco-based start-up that offers one-on-one fitness training online using new technology - this is an important strategic acquisition, as it helps WTW establish foothold in Silicon Valley community and help to develop technology opportunities as part of its technology overhaul
- The B2B healthcare initiative is progressing, with the intention that capability will be in place by 2015 to take advantage of healthcare opportunity with employers and other entities. In March 2014 launch of diabetes product within direct employer channel, aimed at corporate employees with Type 2 diabetes - members are paid with certified diabetes educators and dieticians trained in Weight Watchers approach
- Fitness monitors - currently working on opening up WTW platform to wearable fitness monitor market, and expect to launch platform with a leading fitness monitor player in Europe during FY14, building on experience gained from WTW's own ActiveLink device
There is evidence emerging that wearable fitness monitors are beginning to lose traction already, with the Financial Times recently reporting that Nike is considering discontinuing its FuelBand device. Nike recently confirmed it was laying off staff from its digital sports team and refused to commit to future device launches, although it insisted the FuelBand remained an "important part of our business." One commentator indicated that if Nike, which has one of the longer track records in the nascent wearable fitness monitor segment, is withdrawing from this market, this may indicate poor longer-term prospects. If Nike, a leading global sports company, was selling enough of these monitors, it would continue this product line given the supposed high-growth prospects associated with all wearable technology. Withdrawing from this market already suggests that its FuelBand product is not selling well. If this is the case, then it suggests that the wearable fitness monitors, which consumers have trialed extensively to the detriment of WTW's products and services, may simply be another fad - something that management has already asserted and which I propose in my recent investment note linked above.
While WTW is moving to leverage its offering to the wearable fitness device segment, I believe the strategy to partner with a leading player rather than reinvent its own ActiveLink device is the most sensible option. As the Nike case demonstrates, the wearable device segment remains a nascent one fraught with challenges as the capabilities of wearable technology are still being explored, and so the threat of failure is high. Market leader Fitbit recently recalled over 1 million units due to their devices causing skin irritation among users. WTW has learned the challenges from its experience with its own ActiveLink device, of which there are 400,000 users (versus market leader Fitbit which has sold several million units). Rather than incur the high cost of producing a lower margin hardware product (that will eventually become commoditized as Apple and other technology companies enter this market with devices like the iWatch), WTW's management has opted to partner with another player who will bear the hardware cost, and instead leverage its brand and integrate its improved technology platform with a third-party device.
WTW credit opportunity
WTW's debt at current prices provides an interesting potential opportunity for those that believe in management's turnaround plan but still who feel the equity may be too risky. To briefly recap on WTW's debt position:
- Base rate is LIBOR or a base rate at the option of the Company
- Covenant-lite structure, with WTW not required to maintain any financial ratios e.g. net debt/EBITDA or EBITDA/Interest expense cover
- Debt is senior secured, over all assets of the Company, and is guaranteed by certain existing and future subsidiaries
- The Revolving Facility requires WTW to not exceed a specified Consolidated Leverage Ratio of 5:1, if borrowings under the Revolving Facility exceed 20.0% of revolving commitments (i.e. $50 million) at a quarter-end; at 31 December 2013, the maximum Consolidated Leverage Ratio was 5:1, while the actual Consolidated Leverage Ratio was 4.2:1, and balance outstanding on the Revolving Facility was nil
WTW's debt position as at Q1 FY14 quarter-end is total debt of $2.4 bn, with net debt of $2.1 bn.
In February 2014, Moody's downgraded WTW's credit rating from Baa1 to B1, citing "Unexpectedly poor operating results in early 2014 - in particular, accelerating declines in meeting recruitment, paid weeks and attendance - will result in sharply reduced profits and cash flow this year, and raise financial leverage considerably," adding that "Consumer demand for weight management is likely to be high and Weight Watchers is still the market leader, yet the company's strategy for regaining market share lost to new alternatives is uncertain."
Moody's also stated that "The ratings outlook could be stabilized if new products or marketing campaigns lead Moody's to expect meeting attendance, paid weeks and internet revenues to bottom during 2014, leading to overall revenue and profit stability, resulting in debt to EBITDA of less than 6 times and free cash flow to debt of about 8%."
Investing in WTW's debt would therefore appear highly risky should the recent negative trends continue. However, from the Q1 FY14 update, the signs of stabilization appear to be the there. The investment merit of WTW's debt is therefore worth considering at current prices:
At a current price of $79.375, the most interesting piece of debt within WTW's capital structure is the $2.1 bn Tranche B2 term facility maturing in 2020. The appealing characteristics of this credit are:
- Senior secured facility - first ranking in any distressed scenario should WTW's performance deteriorate further
- Maturity profile - facility matures in 2020, allowing WTW management time to implement turnaround plan and return business to stability and growth
- Floating rate - advantageous in the near to medium term as interest rates should remain low, as debt is less onerous to service given the decline in revenues and earnings; also should help protect investors against any inflation
- Priced at $79.375 as at the time of writing, approx. 21% discount to par value, providing 8%-9% yield to maturity, which is attractive (if one understands the business risks and prospects) for a senior, secured instrument
- Continued stabilization and gradual improvement under the turnaround plan would allow a re-rating of the debt and provide capital appreciation for debt investors
While the covenant-lite terms indicate fewer protections for a lender, something potentially of particular concern in the context of WTW's recent poor performance, at an 8%-9% yield to maturity, I believe the risks around this are already priced into the credit. For the investor than can get comfortable with the Company's present challenges and management's turnaround plan, the covenant-lite structure allows WTW management to focus on turnaround business without worrying over breaching covenants in the near term, resulting in overly aggressive cost-cutting that could disrupt the turnaround strategy.
Another way to consider the debt at current prices is from a "loan-to-own" perspective, being a strategy where the investor can effectively acquire the Company via a back-door strategy as follows:
- Tranche B2 is currently priced at $79.375, or $1.7bn total market value
- Trailing 12 month (TTM) EBITDA is $444m
- Should the business deteriorate further and debt holders move to enforce on WTW, wiping out the equity, the debt investor would effectively acquire the Company at a multiple of 3.75x, an extremely low multiple for a business of this scale, track record and prospects. Of course, this TTM EBITDA is likely to contract further in FY14 given the challenges openly articulated by management. However using Moody's EBITDA estimate of $325m for FY14, this still implies a very low effective acquisition multiple of 5.1x
- While it could be argued that these seemingly low multiples would rise significantly in the event that the business deteriorates further, as I outlined in my recent investment note on WTW (linked above), current pricing on the debt implies an effective acquisition multiple of 5.9x based on my normalized sustainable FCF estimate of $290m under my base case scenario. Again this would undervalue a company of WTW's scale, track record and prospects
- Furthermore, if under an enforcement resolution strategy the debt holder were to opt for a debt restructuring via a debt-for-equity swap, the upside could be significantly higher than par value. Upon a successful turnaround of the business, equity value would recover post-conversion, and would accrue to the debt holder, who will have locked in an entry price at 5x-6x normalized FCF at current prices.
The near-term business outlook for WTW remains difficult, and operational and capital structure challenges remain. However, the business is beginning to stabilize, with management delivering some early success in implementing the turnaround plan, as borne out in the Q1 results being ahead of both guidance and consensus.
From a re-examination of the business, its industry trends and its prospects, I believe the investment fundamentals for WTW remain sound and my investment thesis remains intact.
I may consider increasing my portfolio position in WTW in due course.
Notes & Sources:
- Financial information for WTW has been sourced from Company's 8-K filing for Q1 FY14 unless otherwise stated
- Management guidance and commentary sourced from FY13 year-end and Q1 FY14 earnings call transcripts
- All charts and graphical analysis has been prepared by the author, IndependentValue, using primary source information disclosed in the Company's SEC filings unless otherwise stated.
- All forward-looking financial projections and estimates have been prepared by the author using proprietary analysis unless otherwise stated.
Disclosure: I am long WTW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.