Flat Is The New Growth For The U.S. Weight Loss Market - For Now

Includes: MED, NTRI, WTW
by: John LaRosa

There's one thing I know after tracking the U.S. weight loss market and all ten of its subsegments since 1989 - it's never dull. There is always something dynamic happening in this huge $61 billion market. There are literally thousands of competitors now, much more so than in the 1970s and 1980s - pre-Internet age. And, these competitors run the gamut from one-person entrepreneurs to multi-billion corporations.

That's what makes it so dynamic. In the 1980s, the "brick & mortar" diet center model was successful, growing mainly via franchising. Jenny Craig, LA Weight Loss, Nutrisystem (NASDAQ:NTRI), Diet Center and others grew strongly and quickly, led by CEOs with very large egos and growth plans. Even with substantial overhead costs and the need for 3-5 employees per center, these facilities were able to earn profit margins north of 20%.

However, this has all changed with the Internet era, beginning in the mid-1990s. Now, rather than traveling to a weight loss center to meet with a diet "coach", "consultant" or "counselor," one can access this advice readily 24/7 online, by phone, or via email. The old brick & mortar model, at least for commercial diet centers, is outdated, and profit margins have fallen to less than 9% of sales. Diet companies are reaching customers more often where they work, live and play, instead of asking them to come to a center.

The advent of the Internet age has also lessened the barriers to entry, and the cost. Today, anyone can set up a weight loss website, or become a multi-level marketing (MLM) "distributor" of weight loss products. This has worked very well the past five years for companies such as Medifast (NYSE:MED) and Herbalife (NYSE:HLF). In fact, Herbalife is now the number two weight loss company, by sales, in North America, with estimated net retail sales of diet products (meal replacements) of $537 million in 2012, second only to Weight Watchers (NYSE:WTW).

Although technically it sells vitamins and supplements, it still must be considered a major player in weight loss. At the current price though, despite strong growth, we would not consider it to have much upside potential.

Historically, the long-term annual growth rate of the weight loss business has been 6%. But, with the Great Recession, this came to a halt in 2008. Since then, growth rates have fallen to 1-2.5% per year, 1.7% last year. This is a new era for weight loss companies, despite rising or still high obesity levels in America.

We are now in a do-it-yourself industry cycle, where dieters are just as likely to buy a celebrity diet book (The Fast Diet, The Paleo Diet, The Dukan Diet, etc.), buy weight loss supplements via an infomercial or an Internet ad, or go to their local Wal-Mart (NYSE:WMT) and buy a nutrition bar or shake sold by Slim-Fast or dozens of other private label brands, or use a free or low-cost diet website. Dieters are fickle and very cost conscious as well. The typical dieter makes 4-5 weight loss attempts per year.

When it comes to dieting, Americans are simple: they want a product or program that works, that works quickly, is easy to use, is safe, and has as low a cost as possible. After all, dieting is hard. It takes effort, commitment, and a lifestyle change. And to top it off, you have to PAY for all this work and deprivation!

This do-it-yourself cycle (83% of America's 108 million dieters by our estimate) has grown since 2007. The DIY share 10-15 years ago used to be 70%. This shift is due to necessity. The recession hurt disposable income, as workers were laid off or shifted to part-time work. A typical $1,000+ 3-4 month weight loss program became a luxury for budget-conscious, time-pressed, and stressed out consumers hit by rising gas prices, unemployment, and a payroll tax increase in Jan. 2013.

Contrary to simplistic analyses by some that blame it all on newly popular apps such as MyFitnessPal and others, the real reasons for the current diet business funk are more numerous and more complicated. Following are the reasons why Marketdata believes that market growth has disappeared:

* We are in a false economic recovery. The overwhelming share of new jobs created are part-time, in the service sector, with low pay of about $12/hr. A $25,000/year job doesn't leave a lot of room for a $1,000 diet plan. The Administration doesn't seem to be doing much to help small business (where 80% of America's new jobs are created), so we don't think this situation will improve over the next three years.

* The Affordable Care Act will induce employers to shift workers from 40 hr. workweeks to 29-hour weeks, thereby classifying them as part-timers, who are not eligible for health insurance. This will depress wages further.

* Fad diets and diet books are as plentiful as ever: gluten-free diets, HCG drops, acai berry drinks, pure green coffee bean extract, medical tongue patches, etc. These are heavily promoted via email, mail order, retailers and the Internet. They compete with "legitimate" weight loss programs (i.e. Weight Watchers, Nutrisystem, Jenny Craig, Medifast, etc.).

* Free and low-cost diet websites and apps for smartphones compete and have become increasingly popular with DIY dieters. They are being well-funded, as in the case of MyFitnessPal recently obtaining an $18 million investment and claiming 40 million users.

* Dieters are confused by so many weight loss options and claims. Celebrity endorsements don't carry the same weight as they used to. Consumers know they are being paid millions, are getting the diet program free of charge, and have the means to hire a personal trainer and chef if they desire. This is not reality for most consumers since they can't afford it.

* There is a trend toward eating "cleaner," and away from processed packaged foods, including shelf-stable diet foods sold by Jenny Craig, Nutrisystem and others. In fact, sales of frozen entrees such as Lean Cuisine, Healthy Choice and other brands have been flat for about five years now.

* There is a lack of weight loss programs for niche groups. The big diet companies are still focusing mainly on the core customer -- a 35-year old housewife with several kids and 30-40 lbs. to lose, willing to spend $1,000 on a diet program. Guess what? This group has shrunk. Where are the diet programs for Blacks, Hispanics, overweight teens, people with food allergies, and seniors? We do see more focus on male dieters and seniors by companies such as Nutrisystem, but not by Weight Watchers. Typically, women represent 80-85% of dieters using structured programs. Men tend to do it themselves, working out more at the gym, skipping meals, and using anonymous methods such as meal replacements.

* For the 2013 "diet season" (Jan. 1st to Memorial Day), none of the big diet companies launched anything truly new or compelling. The companies just came out with minor tweaks to their programs and hit us hard with celebrity-filled ads a la Mariah Carey, Jennifer Hudson and others. This wasn't enough to attract lots of dieters.

* Finally, we had a lot of bad snowstorms in the Midwest and Northeast that hurt attendance at diet centers. Yes, the weather DOES affect business, as do wars in Iraq and other calamities.

Add all these factors up and assign each one a 1% negative effect on sales, and suddenly a potential 10% sales gain turns into 0% growth. However, in this competitive economic environment, this is not all bad. If a diet company can maintain sales at last year's level and still be profitable, with some cash cushion and plans to enter higher growth niche market segments, they are in a good position, in our opinion.

Medifast seems to be well positioned, due to its MLM growth engine (Take Shape for Life division), which accounts for 65% of total sales. In addition, MED has 120 medical clinics, thus straddling both the commercial and medical weight loss segments. Added to that, they are moving into Mexico and Canada, thus providing geographic diversification. The company has no debt. The stock price, again, at current levels, doesn't provide much upside. A possible entry point might be in the low 20s, with potential to get to the low 30s in 6-12 months.

Nutrisystem, with a new CEO and new marketing managers, is pursuing such niche markets as seniors and male dieters, as well as the diabetic market, and devotes about 20-25% of sales to marketing. With a marketing budget of $100 million/year, they have to be considered a serious competitor, with a track record in the diet business dating back to the early 1970s. At current price levels, the stock seems undervalued. We could see it doubling within 12 months if the economy improves and they make more headway in these niche segments.

Weight Watchers' stock at current levels in the mid-30s seems to us to be the long-term buy of choice. If management makes meaningful changes for the 2014 diet season, and the economy improves, watch for significant gains. The company is still the market leader, with many advantages over competitors, such as:

- Weight Watchers.com, with $500 million in revenues and growing

- an unblemished record of PR and lack of controversies

- the market's best quality group leaders, with the longest tenure

- an affordable and flexible plan that uses regular food and doesn't make company diet food a mandatory purchase

- international footprint

- leader in the worksite-based meetings business

- excellent cash flow

- excellent brand name recognition, over 50 years

- lack of exposure to risky medical plans or diet drugs

- a loyal following and a database of 10 million customers that they leverage very well via direct mail, email and other methods.

Once WTW gets past the probably temporary effect of phone apps, new management finalizes plans for 2014, and if the economy improves, we look for a stock price in the 50s within a year. The downside risk at these prices is minimal.

That's basically it in terms of possible plays for public weight loss companies. Jenny Craig is owned by Nestle, and has been posting sales declines the past two years anyway, hampered by the price of its company diet food ($400+/month). Only recently has the firm introduced a more affordable monthly plan.

Marketdata estimates that the total U.S. weight loss market grew by only 1.7% in 2012, to $61.6 billion. In late 2012, we had forecast 4.5% growth in 2013, but in view of the above factors, this will most likely be too optimistic. The last recession DID impact the business, with flat growth in 2009-2010, 2.5% growth in 2011, and 1.7% estimated for 2012 - all below the historical average of 6% annual growth.

This is the year of the turnaround. Ediets.com was taken over by As Seen On TV (a direct marketing firm). Nutrisystem last Fall replaced it CEO and marketing managers. Weight Watchers' CEO of 14 years, David Kirchoff, resigned abruptly on July 31.

So, what's a weight loss company investor to do? One thing investors should look for are companies that control costs and get the most for the marketing dollar. That's the obvious and easiest. Secondly, they should look for firms that are willing to enter the niche markets that are untapped or underserved (mentioned above). Also, look for diet companies that can diversify geographically, and get into the Mexican or Canadian markets. Canada's weight loss market is estimated to be worth 10% of the U.S. - or $6 billion. In the future, China will no doubt be a huge market as their affluence (and waistlines) grow.

Furthermore, look for weight loss companies that cement new partnerships with healthcare-related providers and retailers, in non-traditional sites. These may include shopping malls, OB/gyn practices, and the growing number of health mini-clinics found in Walgreen (WAG) and CVS (NYSE:CVS) drugstores. There are 1,400 of these sites nationwide currently, but this is expected to nearly double by 2017. In fact, Nutrisystem is doing just that, by offering its program at Costco (NASDAQ:COST), via the QVC cable TV channel, and 2,000 Wal-Mart stores.

Look for diet companies that go after the corporate wellness market, and large healthcare systems. Weight Watchers has a head start in this segment, providing at-work programs at 4,500 companies nationwide. New start-ups such as Retrofit and Balance Health are also actively catering to this market.

In conclusion, to succeed with investing in the small group of public weight loss companies, look first and foremost for firms that have very good management and an unblemished reputation. The company must treat the customer fairly and be transparent on pricing and what services the client will receive. As basic as this sounds, there have been many disasters in this market over the past 25 years related to this issue -- the most obvious one being the bankruptcy of LA Weight Loss Centers, which went from 850 centers to nothing. You can only scam the public for so long with deceptive advertising and high pressure sales reps.

Target for investment the diet companies that diversify and use multiple channels of distribution, with different price points, including: some centers (maybe), an online service, apps for mobile devices, phone or email support, MLM, social media, etc. Small to mid-sized medical weight loss chains seem to have grown well the past five years, as obesity and diabetes have become bigger health issues.

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.

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