The combination of an asset-light business model and a strong brand can be tremendously powerful, and Weight Watchers (NYSE:WTW) clearly has the sort of returns on capital that bespeak a quality business. Unfortunately, operational stability has proven elusive and the company's decision to launch a large buyback is going to stretch an already stressed balance sheet even further. (For related reading, see A Breakdown Of Stock Buybacks.)
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A Slightly Soft Fourth Quarter
Although Weight Watchers' reported fourth quarter results were OK, they were not as strong as the sell-side projected. Sales grew almost 13%, but were a bit shy of expectations despite being around a 60% jump in online revenue. Total paid weeks did climb nearly 34%, though, and North America's meeting revenue rose about 8%.
Profitability was good, but not quite good enough. Gross margin rose more than three and a half points (a lucrative Internet business helps here), while adjusted operating income rose just above 24% and operating margin expanded two and a half points despite a 29% increase in marketing expenditures. With all of that said, expectations were already demanding and Weight Watchers met its quarter only through a lower than expected tax rate.
Attendance Proves Wiggly
It probably shouldn't be surprising that a diet or weight management company would see erratic attendance - people try it a while and quit, or stick with it just long enough to reach particular goals. That said, North American attendance growth slowed in the fourth quarter - up 5.5% versus better than 13% growth in the third quarter - which was not only better than guidance (flat), but solid given the tough comp created by the Points Plus launch a year ago.
Ex-U.S. attendance is still more difficult. The small U.K. business is doing pretty well, with attendance growth accelerating to 13% in the fourth quarter (versus a 10% growth in the prior quarter), while attendance on the continent was down about 4% (better than the 15% drop in the third quarter).
Weight Watchers Seems to Be Addicted to Debt
One of the curious moves coming out of this quarter was the announcement that management is launching a share repurchase worth up to $1.5 billion. The company will be allocating $720 million to a modified Dutch auction (with pricing between $72 and $83), and then spending a matching amount repurchasing shares to maintain Artal Holdings' stake at 52%.
Remember that Weight Watchers already had negative equity coming out of this quarter, and the company intends to fund this largesse with still more debt. This should be a controversial move. I get that Weight Watchers has an asset-light model that generates prodigious margins and returns on assets or capital. But I've also seen many great businesses commit deferred suicide by gorging on cheap debt that couldn't be productively applied to growing the business. (To learn more, read How Buybacks Warp The Price-To-Book Ratio.)
Can Competitors Touch Weight Watchers?
Debt concerns aside, does Weight Watchers really have any organized competition that's worth fearing? Nutrisystem (Nasdaq:NTRI) and Nestle's (OTCBB:NSRGY) are really the only other organized competitors that fill a similar niche, and Weight Watchers is well ahead of them - so much so that insurers like UnitedHealth (NYSE:UNH) will pay for Weight Watchers in some cases.
There are a host of companies trying the nutrition angle - whether it's supplement companies like Medifast (NYSE:MED) and Herbalife (NYSE:HLF) (who don't have clinical data to support their approaches), or the nutrition businesses of larger concerns like Abbott Labs (NYSE:ABT) or Kellogg (NYSE:K).
Should any of these companies really worry about Weight Watchers? Based on what we've all seen so far, the answer would seem to be "no." Sure, a pill, shake or other nutritional "magic bullet" might be a threat, but nobody seems inclined at this point to put one into clinical trials and the current pharmaceutical approaches in the pipeline still have an uncertain path to the market.
The Bottom Line
I don't think I could ever be comfortable owning a company where management seems so willing to lever up the business - were the U.S. economy to hit another rough patch or an alternative approach like a safe and effective pill to come out, repaying that debt could become problematic.
That said, Weight Watchers has a great brand, excellent online growth potential and a shareholder base that thus far hasn't been too bothered by the balance sheet. Assuming that above-average online sales continue and pull up free cash flow conversion with them, these shares are probably around fair value. (For additional reading, check out The 4 Basic Elements Of Stock Value.)
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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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