More Yo-Yo'ing At Weight Watchers

By Stephen D. Simpson, CFA | November 11, 2011 AAA

Weight Watchers (NYSE:WTW) is one of those oddly volatile stocks. Although the company's inconsistent attendance history and highly levered balance sheet no doubt explain some of it, it is curious that this is a Wall Street plaything. With the company offering disappointing guidance on attendance, it looks like this earnings cycle is just feeding that volatility engine once again. (To know more about analyzing a business, read How To Evaluate A Company's Balance Sheet.)
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Good Performance All Around
Weight Watcher's third quarter was actually pretty strong in many respects. Revenue was up almost 30% as reported, and more than 26% on a constant currency basis. Paid weeks rose 38% and overall attendance was up 9%. North America was strong - revenue was up almost 25%, paid weeks were up almost 26% and attendance jumped more than 13% (though was up just about 5% on a rolling two-year basis). International was not so strong - revenue was up just 7% in constant currency and attendance growth barely surpassed 1%.

Profitability was pretty encouraging as well. Gross margin rose more than four points, due in part to the strong growth in the company's internet business. Operating income was up nearly 50% and operating margin expanded about five points, even with over 50% growth in marketing expenses.

Where's the Global Growth Story?
Weight Watchers is a notably North America-centric company, and it cannot be solely because Americans are the only ones in the world who are fat. Perhaps some of the sluggishness in Europe can be tied to the ongoing financial problems, but investors should not ignore the possibility that the company is falling victim to familiar problems - namely, the popularity of other diets like the Dukan Diet.

What's more, Weight Watchers needs to do more to expand its emerging market presence. It is true that obesity is not at epidemic proportions in markets like Brazil, India and China yet. It is also true that supplement companies like Herbalife (NYSE:HLF), Usana Health Sciences (NYSE:USNA) and Nu Skin (NYSE:NUS) do not necessarily sell so much weight loss product in these fast-growing markets as other supplements. Still, obesity is recognized as a growing problem in these markets and Weight Watchers needs to be there - presuming that they can find a way to make their meetings-oriented approach work in these markets. (To know more about emerging market, read: What Is An Emerging Market Economy?)

Internet Still Growing
I have long thought that one of the issues with Weight Watchers (as opposed to alternatives like Medifast (NYSE:MED) and Nutrisystem (Nasdaq:NTRI)) is the meetings-based format. Simply put, a lot of people are going to tell themselves that they don't have the time (or desire) to attend meetings. That makes Weight Watchers' internet business a key growth opportunity. So far, so good, as internet revenue rose nearly 69% this quarter and it's now almost one-quarter of the revenue base.

The Challenges Are All Familiar
Weight Watchers seems to have the same set of issues to confront. Guidance for flat attendance trends in the fourth quarter spooked the Street and well they should. Weight Watchers has long struggled to maintain consistent attendance growth - attendance fluctuates with new programs and incentives, moves from rivals like Nestle's (Nasdaq:NSRGY) Jenny Craig, and whichever fad diet or celebrity spokesperson currently captures attention.

Long term, the fact that there is medical support to the Weight Watchers approach may help. Weight Watchers should try to leverage the heck out of this by working closely with health insurance companies and large corporations to bring those programs to more people. But the reality is that most potential customers don't read medical journals, don't really want to stick to a slow-and-steady program, and would rather wait and hope for a pill from Vivus (Nasdaq:VVUS) or Arena Pharmaceuticals (Nasdaq:ARNA) or a supplement from Herbalife, GNC Acquisition Holdings (NYSE:GNC) or Vitamin Shoppe (NYSE:VSI).

The Bottom Line
Weight Watchers, like many health companies, produces eye-popping returns on capital and strong free cash flow margins. But it is also a name that is well-loved on the Street and rarely ever cheap. Even excluding the company's whopping debt load, this stock just does not look cheap on the basis of a probable revenue growth and free cash flow margin scenario.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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