By Peter Wahlstrom, CFA
With its widely recognizable PointsPlus and ProPoints programs, Weight Watchers (WTW) has established not only a successful weight management program but a business model that generates substantial cash flow. We like the long-term prospects of this wide economic moat firm, but we acknowledge that the next few quarters could be choppy, given recent miscues. Specifically, in the first six months of 2012, Weight Watchers reported hiccups related to its emerging corporate and international businesses, and management has drawn criticism over the timing of its $1.5 billion "modified Dutch auction" tender offer. Since mid-March, shares are off 36%, compared to a 1% drop in the S&P 500 Index.
Shares currently sit in 4-star territory at a more than 30% discount to our $77 fair value estimate and, at 11.6 times our 2012 earnings per share estimate, we view Weight Watchers' stock as a solid medium-term idea for investors. We believe that as global macroeconomic headwinds normalize over the next few years and as the firm laps its largely self-inflicted slips, Weight Watchers can deliver double-digit earnings growth while generating returns on invested capital of nearly 40%.
A Heavy Revenue Stream
Weight Watchers' strong reputation in an otherwise fragmented and at times disreputable industry has earned it a wide moat. The company's focus on sustainable weight loss has built its brand reputation to the point where food manufacturers are licensing it for use on their products. In our view, it would be extremely difficult for a competitor to replicate the company's 45,000-member-driven group meetings per week where fee-paying customers gather to talk about the challenges of weight loss. The meetings are run by 12,000 group leaders--each of whom has lost weight on the Weight Watchers program.
The Weight Watchers business concept has grown steadily, evolving over the last 50 years to become the world's leading provider of weight management services. In 2011, consumers around the globe spent nearly $5 billion on Weight Watchers-branded products and services, both in person and online. We estimate that worldwide meeting attendance in 2012 will exceed 52 million, while the number of weightwatchers.com subscribers will top 2 million.
Obesity in the U.S. is more common than many believe (or will care to admit), fueling the $61 billion weight management industry. By most measures, the statistics are staggering: More than one third of U.S. adults (35.7%) are obese. No state met the nation's Healthy People 2010 goal to lower obesity prevalence to 15%, and no state has a prevalence of obesity below 20%. The number of states with an obesity prevalence of 30% or more increased to 12 in 2010 from nine the previous year. The Centers for Disease Control and Prevention has reported that roughly seven in 10 American adults over the age of 20 are considered either obese (35.7%) or overweight (34.4%).
Obesity-related conditions include some of the leading causes of death: heart disease, stroke, Type 2 diabetes, and certain types of cancer. In 2008, medical costs associated with obesity were estimated at $147 billion; the medical costs paid by third-party payors for people who are obese were $1,429 higher than those for people of normal weight. According to Marketdata Enterprises, the weight management industry posted 2010 revenue of approximately $61 billion--in the U.S. alone.
Yes, everything is generally bigger in the U.S., but weight is not just a domestic issue. A number of populous and wealthy nations are experiencing similar struggles. According to the World Health Organization, first-world nations joining the U.S. with more than 20% of its adult population considered to be obese are: Saudi Arabia, United Arab Emirates, Mexico, Canada, the United Kingdom, and Greece. We estimate that nearly 40% of Weight Watchers' weekly meetings are conducted outside of the North American market. In our view, the company's approach can be successfully modified to appeal to individuals outside of its traditional U.S. marketplace. In 2011, more than 30% of the firm's net meeting fees were generated internationally, a percentage that essentially has remained flat since 2007.
Not Just a Storefront Business Anymore
Weight Watchers is branching out and improving its brand image. For many years, Weight Watchers seemed content to let its grassroots marketing efforts run the show while counting on a steady stream of revenue from its franchisees. Today, the company is aggressively updating its image and technology while targeting new members, both domestically and internationally. In short, Weight Watchers has done a solid job of upgrading its brand appearance.
It has been interesting to watch Weight Watchers evolve from a firm with a somewhat stodgy (almost homely) brand perception, to one that has numerous celebrity (and everyday user) endorsements. For example, Jessica Simpson, the 31-year-old singer and new mother, was the latest to sign on (at a reported $3 million to $4 million) and is hoping to lose 50 pounds during the next five months.
Another of the firm's smart decisions was to target a great unknown--men. In the first quarter of 2012, men accounted for 15% of U.S. sign-ups (thanks to using another celebrity spokesman, Charles Barkley). Although the aggregate weight management need isn't as high among men and they are only half as likely to actually address this need (according to management), this segment is underpenetrated. So far, men have gravitated toward the firm's nascent online points system and their retention cycle has been slightly longer than the online average (nine months). While it will take time for Weight Watchers to get its men's marketing strategy "right," we like the business model and revenue opportunity, which could add $200 million in incremental revenue in the next five years.
The opportunity is global, but Weight Watchers' North American Company-owned (NACO) business remains in the spotlight. The company is making progress toward upgrading its locations in this region, but it has been behind schedule in its renovation planning (management had expected to complete 50% by the end of last year but only reached 25%). We estimate that each upgrade costs $75,000. In order to deliver a 20% return on investment and one-year payback period, Weight Watchers would need to add an incremental 250 new customers per location (assuming no dropouts). This is no small task (we estimate this may require a 20% uptick in enrollment), but one we view as achievable.
Switching to the Online Channel
Part of the allure in the Weight Watchers model is that the company operates a business that is not capital-intensive (2%-5% of sales) and where customers are increasingly paying in advance of the services received. This generally translates into meaningful cash flow generation ($1.7 billion in cumulative cash flow from operations since 2007), negative working capital, and near-40% returns on invested capital. As the company cycles through its NACO upgrades and information technology investments, we believe that structurally higher normalized margins can emerge, thanks to further penetration of the online segment.
We estimate the online channel could be 2 times more profitable than the physical meetings business. In 2011, weightwatchers.com contributed 22.2% of total revenues, or $400 million, up from $200 million in 2009--a 43% compound annual growth rate. We think that online revenues can increase at a low double-digit rate through 2016 and ultimately account for 30% of total firm revenue.
Volatile and Undervalued
Trading at a 32% discount to our fair value estimate of $77 per share, we view Weight Watchers' shares as undervalued. This stock has been the definition of volatility during the last 18 months, moving more than 3% in one of every five trading sessions. But we see a nearly 50% upside from current levels, believing Weight Watchers will be able to increase revenue at an average annualized rate of 7% over the next five years (on top of the 25% growth realized in 2011). In our view, this firm (one of the few wide-moat names in our consumer coverage universe) will drive growth by expanding its customer base to include men, increasing Internet penetration, and growing internationally.
While there are plenty of moving parts (macroeconomic, competitive, and operational) to the Weight Watchers story, we generally like the firm's growth prospects. With shares trading at roughly 11.6 times forward earnings after the recent sell-off and down 6% year-to-date (versus a 9% gain for the S&P 500), we encourage long-term investors to take a close look. We readily acknowledge that there are still near-term headwinds and we don't necessarily anticipate a quick rebound, yet Weight Watchers has a solid operating model and is poised to benefit from secular (health-related) tailwinds for years to come.