For the true long-term investor who is interested in truly extraordinary returns, it is necessary to do things differently than the crowd. As the crowd spends their time searching for short-term opportunities to appease investors who are inherently interested in short-term results, the true long-term investor is free to search and wait for wonderful companies to become fairly priced. The hard thing is waiting for these wonderful companies to fall to an attractive price while the market continues to march higher and higher. The treat is finding a wonderful company, within your circle of competence, trading for a very fair price.
Weight Watchers (NYSE:WTW) is a wonderful company and despite some near-term headwinds in recruitment and uncertainties with the new management's strategic plan, it is for certain that obesity will continue to rise throughout the world. Fad diets have come and gone, yet Weight Watchers has continued to be the leader in weight management services. Weight Watchers' brand and differentiated product provides a sustainable competitive moat that could lead the company to be at the leading edge of the fight against obesity for many years to come.
I will first describe the obesity epidemic and I will back up the efficacy of Weight Watchers service/brand showing that it is unmatched, creating a wide competitive advantage. Then, I will describe what constitutes a wonderful company and why Weight Watchers fits that mold so well. The market is giving investors a chance to own a wonderful company at a very fair price and near-term catalysts are set to send shares 60% higher over the next year. The focus, however, should be on the long-term business prospects and how performance could continue to compound money at 15% a year over the next ten years.
Overview and History
Our hunter-gatherer ancestors needed to survive when there was not any food around, so their bodies had to be able to store energy when food was available to be able to survive when food was scarce. As human populations have progressed from hunter-gatherers into agrarian and now to industrial nations, our bodies still react in the same ways that our hunter-gatherer ancestors' did. Developed countries now have plentiful amounts of food available and even though whole foods can be found any time of year, processed foods are widely available, cheap and don't require any preparation, making them more popular. At the same time, developed countries have lower activity levels even with greater availability of food. All these factors have led to a growing proportion of overweight and obese people throughout the world.
According to the World Health Organization (WHO), obesity has doubled since 1980. In 2008, 1.8 billion adults, 20 and older, were considered overweight or obese. This trend is unfortunately growing throughout the world and is estimated to reach approximately 3 billion people by 2015. The problem will continue to grow as eating patterns and a sedentary life-style become more common in developing countries.
Source: Harvard School of Public Health
Something has to be done to bring effective weight loss to the masses before obesity reaches ever greater proportions. Fortunately in 1963, Jean Nidetch a Brooklyn home-maker started a weight loss class with a few friends which was the beginning of Weight Watchers. 50 years later, Weight Watchers has grown its operations in 30 countries and with their effective meeting structure, they have helped millions of individuals lose weight. Tens of thousands of meetings are run each week with meeting leaders instructing customers in proper eating and exercise habits, behavioral modification and providing group support to provide an atmosphere of healthy lifestyles.
In 2011, the weight management industry had revenue of approximately $62 billion in the US alone. Weight Watchers had $1.826 billion of revenue in 2012 spread out over 30 countries. This shows us that the weight management market is extremely fragmented and WTW has plenty of room to grow with the ever larger populations of overweight and obese throughout the world.
Why I Believe Weight Watchers Is Set to Gain Large Market Share in the Future
Weight loss actually isn't rocket science and there are people who have been able to lose large amounts of unnecessary weight in a healthy way, for little to no cost.
Weight gain and loss can be boiled down into a simple formula:
Calories in = Calories out = No Change
Calories in < Calories out = Weight Loss
Calories in > Calories out = Weight Gain
If one eats whole-foods instead of processed foods and increases their calorie output through exercise on a daily basis, it is guaranteed that one will lose weight. So, why has obesity grown? Human nature makes it hard for people to change tightly ingrained habits on their own and it doesn't help that living in developed country there are vast supplies of processed food with almost no need to move. This environment makes it difficult for people to get rid of their creature comforts and live a healthier lifestyle.
So then if weight loss is difficult in a developed country what benefit does WTW provide? I could quote the very long list of research that shows Weight Watchers is successful in weight management, however, we have to take notice that the research is more or less funded by Weight Watchers. Now, there could be a conflict of interest for the researchers to prove that Weight Watchers' products are better when compared to all the others and we as investors should ere on the cautious side. I will explain to you why I believe Weight Watchers is effective even though the research might be funded by Weight Watchers and the research isn't perfect.
Many adults have a close relationship with food because of the comfort that it brings. People tend to get extremely defensive when another person tries to change their eating habits. People also like something that is easy to understand. So, a system that allows people to eat what they want and is easy to understand, is a system that is bound to work. Weight Watchers provides a simpler system without the complexities of calories, fats, protein, and carbohydrates through a system called Points Plus. A number is designated to all different types of food, so instead of counting the amount of heat to burn food (calorie), they count these simpler points. Points are much higher for unhealthier food choices while whole foods get greatly lower numbers. The system then incentivizes Weight Watch customers to choose more whole foods in place of unhealthier foods.
Weight Watchers' meetings are a very powerful tool in a person's quest of weight management for the simple fact the meetings are highly influential. Robert Cialdini's book Influence describes six principles of the human condition that incline people to say yes and Weight Watchers utilizes three effectively to help customers say yes to lifestyle changes that will help them lose weight for the long term. Cialdini's research shows that people tend to follow the lead of experts. Each Weight Watchers meeting is led by a person who has been successful in reaching their goals with Weight Watchers, so they provide the best authority to each meeting attendee. Weight Watchers research also backs up Cialdini's authority principle by showing that a group of weight watcher attendees showed a dramatic difference in weight loss when compared to one-on-one weight management counseling with a doctor, an authority figure, but one who might not know what it is like to be overweight/obese and has experienced the obstacles to lose weight. Another principle of influence researched by Cialdini is commitment and consistency which is one of the most powerful tools Weight Watchers uses. Meetings undoubtedly have members write down and verbally agree to a weight loss goal in front of their peers. Cialdini says that people strive for consistency in their commitments and people become more committed when everyone they know and trust knows their goals. The last principle of Cialdini's that is used by Weight Watchers is social proof. Cialdini's research showed that people are uncertain with their choices and tend to look to those around them to guide their decisions and actions. Again, Weight Watchers meetings provide the environment for members to change their behaviors through social proof.
If we take a look at the weight management service competition such as Nutrisystem, Jenny Craig or the multitude of fad diets and free calorie counting and fitness apps, they lack the ease, simplicity and meeting structure that provide what I consider to currently be the best environment for people to manage their weight.
Why Mr. Market is Pessimistic
A combination of a marketing miss in 2013 with the prevalence of free calorie and activity counter app use has led to lower recruitment which will continue to impact WTW's future quarters. The market was extra negative when management lowered guidance for 2014, due to the factors above, and a plan still has not been made public by the new management. Mr. Market is extra fearful when there is any uncertainty with strategy, especially with new management and lower management expectations.
What makes a wonderful business?
It's not a secret that Warren Buffett and Charlie Munger are the biggest cheerleaders for investing in wonderful businesses. They love wonderful companies because wonderful companies have inherent competitive advantages that prevent competitors from reducing their profits, allowing them to compound capital at the highest return over a long time frame. It becomes ever harder to compound capital at high rates when you have to continue to pay Uncle Sam, pay your broker commissions and try to consistently not mistake.
Warren described wonderful businesses to be a company that can employ large amounts of incremental capital at very high rates of return over an extended period of time. He also said that "Most high-return businesses need relatively little capital and shareholders of such a business usually will benefit if the company pays out its earnings as dividends or makes significant share-repurchases."
How is Weight Watchers a Wonderful Business?
First, let's look at WTW's ROIIC:
One way to calculate the return on incremental invested capital (ROIIC) is to take the company's operating income, add depreciation & amortization and divide that by the weighted average adjusted cash used in investing activities.
ROIIC - Return on Incremental Invested Capital
Source: McDonald's 2005 10K
Source: My Calculation
Source: My Calculation
Weight Watchers over the past ten years has been able to compound incremental capital at roughly 17.3% year-over-year and surely passes the ROIIC metric.
My absolute favorite type of company is company that has low capital expenses and assets that immediately throws off cash while expenses are not paid until much later. If a company is able to accomplish this feat, it means that it runs on other people's money! This phenomenon can be found on a company's balance sheet when current assets are less than total current liabilities creating negative working capital. Weight Watchers has significant negative working capital and is able to do this because of their subscription payment based model. 78.7% of WTW's 2012 revenue came from meeting fees and internet revenue. Once a member signs up, a fee is paid that is automatically considered revenue because the service begins immediately. Weight Watchers' normal business expenses are relatively small at 76.9% of 2012 revenue, but they are deferred until later! Expenses consist of salaries, debt interest payments, leases for meeting space, furniture, marketing and web-site development. Weight Watchers needs very little capital to operate with average annual capital expenditures of $105.7 million over the past ten years and expanding does not take large amounts of capital.
With significant Free Cash Flow, WTW has issued a dividend since 2006 and made significant share repurchases over the past ten years reducing shares outstanding from 110 million to 56.3 million or 48.8%.
Source: Various 10Ks
The above charts shows that shareholders who owned Weight Watchers since 2003 would own almost twice as much of the company now and they have been receiving a dividend since 2006.
The way to think about Weight Watchers' long-term valuation prospects is, it is necessary to think like an owner. If Weight Watchers has been able to compound incremental capital the past 10 years at 17% and an average ROA of 20.3%, what should the company be valued at if they were able to continue to compound capital and earnings per share at 10, 15, or 20% the next 10 years?
Source: My Calculations
At 10% CAGR EPS growth, share price would be $165.75
At 15% CAGR EPS growth, share price would be $258.45
At 20% CAGR EPS growth, share price would be $395.65
Keep in mind earnings will not be smooth like this and will fluctuate, but remembering that the market is a weighing machine over the long term, these end results could be possible. We see that a company holding a high return company over many years yields huge results.
Many investors and the market seem to be unhappy that Artal Group, the majority shareholder in the company, repurchased a huge amount of shares at more than twice today's price. What I feel investors do not realize is that Artal is extremely aware of the return on the company's dollar and would agree with Buffett when he said price doesn't really matter when you are buying a wonderful business over the long term. I can give you a visual representation of why by showing the starting price at $80 or the average share price during the modified dutch auction last year.
Source: My Calculations
My estimate would be that WTW should be able to compound at least at 15% and the $80 paid for share repurchases is not too bad, although, buying shares back at today's price would garner huge results.
The market is negative due to the uncertainties of the new management's strategy. So I believe that once the market hears the strategy at the investors conference in November, the share price should revert back to a normal multiple of earnings. High returning companies usually have a multiple of earnings that is 20x and above, but my estimation would be 15x with the gloomy outlook that management has laid out for 2014. That would mean that in the instance that the market had a positive perception of Weight Watchers in the next year could send the share price of Weight Watchers to ~$60, or more than 60% higher than today's share price.
Weight Watchers is in an industry that could gather more competition as time goes on, and another company could come up with a better system through technology or other methods and steal market share. I believe that with the information given above that it would be a monumental feat for a competitor to sustain a method of weight loss on the same scale or larger, in a simpler, cost efficient and safe way for a significant period of time as Weight Watchers has.
Some people also bring up a good point that a drug could come to market that would lead to significant amounts of weight loss effortlessly. I believe that a miracle drug is possible but unlikely to be safe and effective. We have had numerous drugs come to market in the past, however, they usually use unhealthy amounts of caffeine or other stimulants to raise the users metabolism. The FDA has stepped in and banned many of those drugs as they have not been deemed safe for prolonged consumption. Weight Watchers' model uses the natural way for people to change their life by changing their diet and increasing their activity.
Also, one thing that could potentially be a problem is the large debt that Weight Watchers has incurred. If the company starts to pay down large portions of debt, shareholders will not receive high returns because management can get higher returns than the 3% interest on the debt. What should be noted is that management has used swaps to lock in a very low interest rate of 3% and with Artal as the largest shareholders, I feel confident that Weight Watchers will manage this debt with the best intention for long-term shareholders.
Speaking of Artal, they have a majority of seats on the board of directors and could run the company in a way that would benefit them and not minority shareholders. I believe that minority shareholders who intend to hold Weight Watchers for a period of 10 years or more would benefit from all the moves that Artal has been instating.
Management also could be in the process of developing a strategy that does not work. That is possible, but I believe with the growth in obesity worldwide and Weight Watchers' current model, over the long-term Weight Watchers is a wonderful company that can be run by an idiot.
Obesity will continue to grow and Weight Watchers has a system that has been proven to help people change their lifestyles helping them lose weight and live a healthier life. Weight Watchers also has many characteristics of a wonderful business and with their competitive advantages, they should be able to continue to grow the business at a high rate. I am confident that new management's strategy will perform well over the long-term and once the market loses its negative perception of Weight Watchers, the share price should move up 60% and continue to compound at a very healthy rate over the next 10 years.
Disclosure: I am long WTW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is meant for instructional purposes and not meant as a recommendation to buy or sell. The only kind of intelligent investing is through your own due diligence.