Weight Watchers International - Is The Fat Lady Singing?

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By Independent Value :

Ick investing means taking a special analytical interest in stocks that inspire a first reaction of "ick." I tend to become interested in stocks that by their very names or circumstances inspire unwillingness - and an "ick" accompanied by a wrinkle of the nose on the part of most investors to delve any further

Dr. Michael J. Burry

With common stocks appreciating by approximately 17% (as measured by the S&P 500) over the last 12 months, it has become ever more challenging to identify attractive investment opportunities. While it is almost universally accepted that the recent rise in common stock prices is attributable to abnormal monetary policy creating an artificial, relative value-driven investment environment, common stock prices continue to rise and there are no clear signs that the advance of the last 12 - 18 months will halt any time soon, despite recent market jitters. It is with this view of the market that I have sought out businesses whose stock prices have not been lifted by the tide of quantitative easing ((QE)) and irrational exuberance that it has engendered. One such business is Weight Watchers International Inc. ([[WTW]] or "the company"), which has declined approximately 50% over the last 12 months, and almost 40% in the first quarter of 2014 alone. It is with such clearly out-of-favour businesses that hidden value and opportunity may be found.

Executive Summary

  • WTW is currently valued at $1.13 bn or $20 per share, a 39% discount to a conservative estimate of its intrinsic value, which I believe is $1.9 bn, or $33 per share
  • This business is available at such a steep discount due to a number of temporary challenges faced by management and the Company, all of which are fixable and do not constitute permanent weaknesses in WTW's business model or prospects
  • Recent reported performance has shown marked deterioration in revenues, earnings and business KPIs, as company experiences significant competitive pressures from free mobile and tablet fitness apps and wearable weight-tracking and fitness monitors
  • WTW also carries significant financial risk due to high level of debt ($2.4 bn, versus shareholders' deficit of $1.5 bn), assumed for the purpose of a share tender offer and repurchase transaction instigated by WTW's majority (52%) private equity owner in 2012 - financial risk is also exacerbated by the deterioration in performance, effectively increasing the leverage within the Company
  • Recent sharp decline was triggered by management announcing that revenues and EPS for FY14 are likely to be down c. 19% and c. 60% YoY, due to increased competition from free mobile fitness apps and wearable fitness monitors,
  • Additionally, a shareholder class action has been filed against the Company and certain current and former officers last month in relation to the circumstances and manner of the 2012 tender offer and share repurchase transaction
  • As a result of current market and capital structure challenges, current consensus is overwhelmingly negative on the company, with an obsolescence narrative gaining traction - consensus view holds that WTW's business model is at best stale and at worst, obsolete, given a paradigm shift within the weight loss industry as more consumers' adopt free apps and fitness monitors, which will inevitably lead to WTW failing due to debt load as revenues and cash flow deteriorate further
  • The market has overlooked the fact WTW remains the leading international brand within the weight management industry by a significant margin, with best-in-class reputation, proven product efficacy evidenced by clinical studies, and a consistent long-term track record of high returns on capital and cash generation in an industry marked by fads and short-lived product cycles, indicating the existence of a competitive advantage
  • The catalyst for realisation of underlying value is the implementation of the turnaround plan currently being implemented by new management and a realisation by consumers that free apps and fitness monitors are simply the latest industry fad, and are not by themselves a viable solution for weight problems. Successful implementation of management's turnaround plan, combined with the gradual subsiding of free app and fitness monitor hype will lead to renewed traction of WTW products and services and therefore a re-rating of the Company's equity

At current prices, WTW represents an opportunity for the enterprising and patient investor to acquire a fractional interest in a best-in-class, high return business with excellent prospects that has temporarily fallen out of favour. The Fat Lady is not singing.

Company Overview

Founded in 1963, WTW is a leading, global-branded consumer company and the world's leading provider of weight management services. The Company operates globally through a network of Company-owned and franchise operations, and has built a strongly recognized brand name among weight-conscious consumers. WTW operates across several international markets, and principally in North America, the United Kingdom, Continental Europe, Australia and New Zealand, and is headquartered in New York.

WTW was acquired from H.J. Heinz & Company in 1999 by Artal Luxembourg S.A. ("Artal"), a private equity group, in an LBO transaction. Under the terms of this transaction, the core meetings business was acquired, with the Weight Watchers food manufacturing operations remaining under Heinz ownership.

Approximately 1 million people attend over 40,000 Weight Watchers meetings around the world on a weekly basis, and in 2013, consumers spent approximately $5 billion on Weight Watchers branded products and services, including meetings conducted by the Company and franchise operators,Internet subscription products sold by WeightWatchers.com, products sold at meetings, licensed products sold in retail channels and magazine subscriptions and other publications.

Industry

Overview

The global weight management industry can be broadly divided into three main segments, namely food diets and products, services (including surgical procedures), and fitness equipment. As such, it comprises everything from low calorie food and drinks, to diets plans and nutrition services, to fitness equipment. The global market was estimated to be worth approximately $265 billion in 2012, and is projected to grow to over $360 billion by 2017 (8% CAGR), according to research firm Markets and Markets. Most recently, Marketdata Enterprises estimates that the US weight management market, the largest market globally, was worth $60.5 billion in 2013.

The key trend, and growth driver within the weight management industry at present is obesity treatment and prevention. Obesity is now viewed as a global epidemic by the World Health Organisation ((WHO)), which estimates that approximately 1.4 billion people globally are overweight, and that over 10% of the world's population is obese. According to the WHO, obesity and overweight conditions are the fifth leading risk for global deaths, with 2.8 million adults dying each year. Overweight or obese people are also more likely to suffer from other serious health issues, including diabetes, heart disease and cardiac conditions and cancer, placing enormous additional burdens on public health systems across the world. The number of overweight and obese people has steadily increased around the world over the past 20 years and is estimated to reach approximately 3.0 billion by 2015, primarily driven by changing eating patterns and increasingly sedentary lifestyles.

The commercial weight management industry segment is highly fragmented and has historically been characterised by fads, including various dieting trends (Atkins, South Beach etc.), and "quick-fix" gimmick products such as diet pills, home exercise equipment, vitamin supplements, diet books, and DVD exercise programmes, all of which have tended not to achieve any meaningful product longevity among consumers. As such, the industry is prone to rapid and continuous change. The market for weight management products and services continues to expand however, given the scale of the obesity problem globally. The latest trend within the industry is the emergence of free fitness apps for smartphones and tablets and wearable technology in the form of fitness monitors that count calories, and track jogging times and distances and other metrics. These products have emerged from the most recent wave of high growth technology trends, mobile computing and wearable technology. As such, these are predicted to grow significantly in the years ahead, while disrupting the business models of traditional weight management businesses such as diet companies.

Successful businesses and products within the industry are characterised by effective marketing and proven product efficacy. Given the fragmented, faddish marketplace, consumers are subjected to regular hype and advertising campaigns for the latest weight loss product or service. Therefore, effective market campaigns are essential to penetrating market noise and reaching consumers. Additionally, consumers seeking to lose weight often try numerous products and services in their efforts to lose weight, and therefore only those products or services that demonstrate proven results develop strong brands that create a competitive advantage over time.

Competition

WTW's main competitors comprise two main types of businesses (1) commercial weight management companies and (2) technology-based weight and fitness products, comprisingInternet and fitness applications for mobile/tablet devices, and wearable devices including calorie counters and fitness monitors. Prominent competitors include:

Commercial weight management companies

Technology-based weight and fitness products

NutriSystem ( NTRI )

MyFitnessPal (online/mobile application)

MediFast ( MED )

Runkeeper (online/mobile application)

Herbalife ( HLF )

Lose It! (online/mobile application)

Jenny Craig Inc. (JC, Private)

FitBit (wearable fitness monitor)

Slim Fast (Unilever [[UL]])

Jawbone (wearable fitness monitor)

Slimming World (UK only, private)

Numerous other free applications & devices

Competitor Comparisons

WTW and HLF dominate the weight management market in the US and globally, both possessing international brands. In terms of reported revenues, HLF's weight management segment generated sales of $3.1 billion, making it the largest weight management product and service provider. Within the key US market however, WTW is the clear market leader, with US sales of $1.2 billion versus HLF's estimated $591 million in 2013. HLF also generates sales from revenue streams not strictly comparable to the WTW business model, including nutritional and vitamin supplements, energy drinks and skin, body and hair care products. NTRI, MED and Jenny Craig are significantly smaller businesses, but provide comparable weight loss products and services.

Internet and mobile application-based businesses represent the most recent challenge to traditional commercial weight management companies.Internet-based applications such as MyFitnessPal ((MFP)) offer exercise and dietary tracking platforms for users to self-monitor and achieve fitness goals, including weight loss. MFP is the leading platform within this segment, with perhaps the strongest competitive offering to the traditional weight management companies - it has built the world's largest nutrition and calorie database (cataloguing over 3 million foods) and has in excess of 40 million users. MFP also has an online community offering viaInternet message boards where users discuss fitness topics. MFP is venture capital-backed, and is valued at approx. $100 million - $120 million based on its most recent 2013 fundraising.

Wearable fitness monitors such as Fitbit and Jawbone are part of the high-growth wearable technology phenomenon alongside smart watches and smart glass devices. Wearable monitors also overlap withInternet and mobile fitness applications, with for example Fitbit partnering with MFP to allow synchronisation of tracked data on Fitbit devices to users' online MFP account.

Business Model

WTW is a subscription business based around its core product, a weight management programme that comprises a range of nutritional exercise and behavioural tools and approaches. This program is delivered to subscribers or "members" who sign up to attend weekly group weight-loss meetings, or through online subscription via the WTW website.

Weight Management Program

WTW's programme uses a proprietary weight management system, PointsPlus, which has been created from scientific research and previous members' insight and experience with weight loss. With the PointsPlus system, each food has a PointsPlus value determined by a unique and proprietary formula based on the food's protein, carbohydrates, fat and dietary fiber content. Members following the PointsPlus system can eat any food as long as the PointsPlus value of their total food consumption stays within their personalized PointsPlus "budget." Since nutritious foods generally have low PointsPlus values, this approach guides customers toward healthier eating habits.

Clinical Efficacy

WTW's programme has been proven to work, and is one of the most clinically-studied commercial weight management programmes, with more than 80 peer-reviewed publications in the last 20 years. In 2012, a clinical trial funded by the National Institutes of Health in the United States found that individuals following Weight Watchers lost more weight, on average, over a 48-week period than those following a programme administered by healthcare professionals preceding a period of time of following Weight Watchers. Furthermore, in 2013, a randomised controlled trial conducted by the Baylor College of Medicine was published in The American Journal of Medicine and found that overweight and obese adults following the WTW programme lost significantly more weight at six months than those who tried to lose weight on their own.

Operations

WTW's operations are organised into two reporting segments:

  1. Weight Watchers International ((WWI)), a meetings business, where paying members learn to lose weight through healthy food plans, exercise, behaviour modification and group support at meetings. WWI also includes ancillary revenue streams from franchise operators, in-meeting product sales, and licensing and other income
  2. WeightWatchers.com (WW.com), anInternet based subscription service, offering online and mobile content and resources, including applications for mobile and tablet devices

WWI Segment Overview

Meetings

WTW's core business has historically been its group meetings business (approx. 50% of 2013 revenues), where members attend weekly meetings usually lasting one hour in duration. Meetings are held by the Company or franchise operators in meeting rooms in conveniently located civic venues, including local community halls, hotels, schools, retail centres or other suitable venues.

Meetings are run by leaders, of which WTW has approx. 10,000 worldwide at present. Leaders are credentialed weight management experts under the Weight Watchers programme who have successfully lost weight and sustained their weight loss through following the programme. As such, leaders are real-life examples of the effectiveness of the programme and are best placed to motivate and inspire members to achieve similar results.

Leaders run meetings by talking to members about their weight loss efforts and educating them about aspects of the programme, including facilitating discussions about weight-related topics, demonstrating weight management strategies, goal-setting and providing encouragement and support to members.

Central to the effectiveness of the meetings business is the group support system. Members support and encourage each other in overcoming their weight challenges in a healthy and sustainable way, by focusing on changes in routines, habits and behaviour with regard to food, lifestyle and exercise. Meetings are interactive in nature and usually commence with a confidential weigh-in of members in order to track their progress on a weekly basis. Meetings effectively create supportive weight-loss communities or networks for members to feel a part of as they pursue healthy and sustainable weight loss.

The fee model for the meetings business is via either a monthly commitment plan called Monthly Pass, or on a pay-as-you-go basis, where members pay on a per-meeting attendance basis. The Monthly Pass model offers unlimited access to meetings and to Weight Watchers eTools, anInternet-based product offering weight management tools and resources. The Monthly Pass is automatically debited from subscribers on a monthly basis until cancelled, and is typically priced at a discount to the traditional pay-as-you-go fee. The Traditional pay-as-you-go fee model involves an initial upfront registration fee, with a weekly fee for each meeting attended.

The key performance metrics for the Meetings business are paid weeks, and meeting attendances. Paid weeks represent the number of weeks paid for by customers via both Monthly Pass subscriptions and pay-as-you-go meeting attendances. The Monthly Pass subscription model is the primary source of meeting revenues, with approximately 75% of meetings paid weeks attributable to Monthly Pass subscriptions in 2013. Attendances refer to customer attendances at weekly meetings.

Also reported within the WWI segment are ancillary revenue streams, consisting of:

Product sales

Product Sales relate to revenue generated from sale of snacks, bars, cookbooks, food and restaurant guides, magazines, fitness kits, PointsPlus calculators, activity monitors. These products are designed to complement the proprietary weight management plans. These products are sold through meetings and franchise operations and account for approximately 12% of total revenues (2013).

Franchise revenue

Franchise revenues are generated from franchisee operators, who typically pay WTW 10% of their meeting fee revenues. Franchise operators are responsible for operating meetings and have freedom to control their own pricing, locations and structure.

Licensing and Other revenue

Licensing and Other revenue primarily comprise revenues generated from the licensing of WTW's brand and IP with selected partner companies for food and other consumer products e.g. Kraft Foods ( KRFT ), Greencore, Weetabix, Parmalat, Yoplait and others. As a legacy of the LBO from Heinz, WTW also has a perpetual royalty-free license arrangement with Heinz (HNZ), who manufacture food products that carry the Weight Watchers brand.

WW.com Segment Overview

WW.com has been the higher growth segment of WTW's business in recent years, and accounted for approximately 30% of revenues in 2013, versus 14% in 2009. WW.com generates revenues via two subscription products, Weight Watchers Online and Weight Watchers eTools.

  1. Weight Watchers Online offers online and mobile content, resources and interactive web-based weight loss plans
  2. Weight Watchers eTools is anInternet-based weight management tool available to meetings members - this provides interactive tools and resources, including mobile applications allowing members to manage weight loss routine and plans

The fee model for both the online and eTools products is a pre-paid subscription fee for initial one or three-month periods, followed by pre-paid month-to-monthly fees until cancelled.

As with the meetings business, the key performance metric for the WW.com segment is paid weeks, being the number of paid online subscriber weeks. In 2013, WW.com had in excess of 1.7 million subscribers.

Revenue Overview

Revenue by segment

  • Meeting fee revenue is the core income stream, but is low growth, with CAGR of 1% over a period from 2009 - 2013, and has declined from 58% to 49% of total revenues
  • WW.com has been the high growth segment, withInternet revenues growing at CAGR of 27.8% over a five-year period, and increasing from 14% of total revenues to 30% of total revenues over the period. Online business has cannibalized meetings business to some extent
  • In-meeting product sales are broadly correlated to meetings business, and have declined from 18% to 12% of total revenues from 2009 to 2013
  • Franchise, Licensing and Other revenues have remained broadly static, at between 8%-10% of total revenues, but have declined as a percentage of total revenues over the period

Revenue by geography

  • North America is the key market for WTW, with 68% of total revenue on average generated from North America
  • UK and Continental Europe are other significant markets for WTW, averaging 12% and 16% of total sales respectively over the period

Network Effect

A key differentiating element of WTW's business model versus competitors is its international network of leaders, franchisees and members, which it leverages to generate recurring revenues from existing and new members. The group meeting format fosters a supportive environment that is central to the efficacy of WTW's weight management system. The meeting leaders help to motivate and empower members to meet their weight loss goals in a safe and supportive environment, which produces successful results. This in turn generates new member referrals by word of mouth, thus creating a powerful network effect - the more people that join meetings, the greater the level of support and interaction, creating a higher likelihood of successful habit and behaviour modification and therefore successful weight loss. This creates more leaders to go "spread the word" about the WTW programme's efficacy, allowing WTW to operate in more locations, easily facilitated via the meeting model's utilisation of inexpensive, conveniently located venues on flexible rent terms e.g. local community halls or schools. This word of mouth element among leaders, members and former members is an important source of new customers with a very low effective cost of acquisition.

Similarly, much like social networking websites, the network effect also extends to WTW's online segment, as online resources facilitate the sharing of weight loss experience, tips and results. The more members who use this platform and successfully lose weight, the more new subscribers it will attract.

This low-cost member network infrastructure, combined with the strong international brand and the effectiveness of WTW's offering, therefore enables it to efficiently attract new and returning customers.

Customer Acquisition

As a consumer-facing services business, the following are crucial for customer acquisition:

  • Marketing is essential for promotion and enhancement of WTW's brand. WTW primarily markets its services via traditional media (television, digital, print) to reach its target audience, as well as social media platforms. The marketing cycle involves three key campaigns during the year, winter, spring and autumn, with the winter/new year season being the peak season for weight loss. A key feature of WTW's mass media marketing campaigns is the use of celebrity brand ambassadors, who promote the WTW service and products in advertising campaigns, in which these brand ambassadors demonstrate how they have successfully lost weight by using WTW weight management plans and services.
  • Product/Service refresh and innovation is also an important component for new customer acquisition. While the core principles underpinning WTW's weight management system tend not to change, weight loss plans require a refresh cycle for content and format every few years in order to keep up to date with consumer preferences and trends. WTW also must develop innovative new services and products and enhance existing services and products to ensure continued appeal to consumers, given fragmented and faddish nature of the market
  • Meeting Leaders are also central to promoting WTW's service offering, and in ensuring the effectiveness of the meeting format. Leaders are examples of the programme's effectiveness to members and therefore serve as accessible role models for members. Leaders organise meetings and sell products, motivate members on weight loss objectives and facilitate a supportive group environment to retain existing members and attract new members. Leaders are paid a base rate for running meetings, and earn commissions based on number of meeting attendees and products sold in meetings
  • Technology investment is also a key area of expenditure, as WTW seeks to maintain and enhance the online offering to compete with free fitness apps and other online-based resources. Ongoing website development costs are therefore an important area of spend as the WTW website is both a gateway for the Company'sInternet subscription products and a global promotional channel for the business. Continued investment in its technology platform is important for WTW to win new members, offer more effective products for people trying to lose weight and grow its online business, which is significantly higher margin than the meetings business

Customer acquisition costs primarily consist of marketing and leader compensation costs, which are relatively low due to effective mass marketing campaigns and word-of-mouth referrals arising from the network effect of member community and WTW's programme's clinically proven offering.

Segment Profitability

  • The WW.com segment earns a significantly higher margin than the traditional meetings-based WWI segment
  • Over the 2009-2013 period, WW.com EBIT margins have steadily increased from 32% to 58%, as online subscribers have increased, while the WWI margins have approximately halved from 24% to 13%, primarily due to declining meeting attendances
  • While the WWI segment has a variable cost structure, with the ability to rent facilities on short-term leases depending on meeting attendance sizes, and leaders are paid on a commission basis in excess of a base rate, there remains a certain level of operating leverage - where attendances and paid weeks drop significantly, leader compensation and venue rental costs are still incurred, thereby causing an adverse volume impact on operating margin, as evidenced in the recent track record

Financial Summary

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Financial highlights from the previous 10-year performance include:

  • Consistently high returns on capital - average ROIC of 40% and ROUNTA of 44% over period
  • Consistent free cash flow generation (before debt service), with average FCF margin of 23% over period, and average FCF/EV yield of 7%
  • Stable and consistent performance - gross margins and EBIT margins averaging 55% and 28% respectively over the last 10 years
  • Significant increase in leverage - average debt has increased 10x over period
  • Significant levels of cash returned to shareholders from free cash generation and leveraging of balance sheet:

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Investment Considerations

Current Market Perception:

WTW's share price has declined approx. 50% over the last twelve months, with 36% of that decline occurring in the most recent quarter to March 2014. The rapid decline in share price can be attributed to the following 4 factors:

  1. Q3 FY14 results in October 2013 included announcement of suspension of dividend, 8.5% decline in revenues versus Q3 FY13 due to declining enrollments, and 11% in net income and warned of double-digit revenue declines if continued negative trends persisted
  2. Q4 and full year results for FY13 reported in February 2014 showed a 6.3% decline in overall revenues YoY, including a first ever quarterly decline inInternet revenues (-5.0%) in Q4 for WW.com, attributable to deteriorating recruitment trends, notably a 10.2% YoY decline in meeting paid weeks, and a 15.4% YoY decline in meeting attendances.
  3. FY14 guidance indicated expected continuation of recent adverse trends, with management guiding YoY revenue decline of 16% to $1.4 billion, and EPS guidance of $1.30 - $1.60 versus consensus estimates of $2.78 and PY EPS of $3.65
  4. FY14 outlook based on increasing competitive pressure from consumer trial and adoption of fitness monitors and free apps for mobile and tablet devices, and ineffective WTW marketing of its products. Management Earnings call for FY13 results referred to a "turnaround" of the business

In addition to the above operational challenges, WTW also faces balance sheet and governance issues:

  • The Company is highly leveraged, with $2.4 billion of debt as at December 2013 year-end, of which $1.5 billion was assumed in 2012 to facilitate a share tender offer worth $720 million, and a share purchase from majority private equity owner Artal worth $779 million, both completed at a price of $82 per share (approx. 4x the current share price)
  • The assumption of this additional debt, combined with the deterioration in recruitment trends and impacts to revenues and cash-flow, has created increased and significant financial risk; Moody's downgraded WTW's debt to B1 and placed a negative outlook on the Company in February of this year
  • A class action lawsuit was last month filed against the Company and certain past and present executives (the "defendants") as a result of the tender offer and purchase of shares from Artal, with it alleged that the defendants "issued allegedly materially false and misleading statements regarding Weight Watchers International Inc' financial performance and future prospects and failed to disclose adverse facts, including that Weight Watchers International, Inc. was experiencing execution issues which were causing it to miss its internally forecasted financial plan;, that Weight Watchers International, Inc. was experiencing a significant drop in its North America and United Kingdom meeting attendance figures, and that Weight Watchers International, Inc. was facing increased competition from free weight-loss apps and its enrolment was being negatively impacted."
  • The class action filing notes that in 2012 CEO David Kirchnoff and CFO Ann Sardini received gross proceeds of $11 million from exercising share options, selling shares in the open market and tendering shares to the Company under the tender offer (Sardini resigned in 2012 and Kirchnoff resigned in Q3 FY13 after poor Q2 results were announced)

On the basis of the above operational, financial and governance issues, the consensus view on WTW may be summarised as follows:

  • Poor management behind recent poor performance, specifically (1) Management underestimated threat of activity monitors and free apps and consequently underinvested in WTW's technology platform, (2) ineffective marketing contributed to decline in member numbers and attendances, and (3) Poor treatment of meeting leaders (low paid, lack of support) leading to leader disenfranchisement
  • Highly uncertain future for the business with risk of business stagnation or obsolescence, as WTW may not be able to recover lost ground versus free apps and fitness devices
  • Significant debt load and increasing financial risk as business performance deteriorates further as per management FY14 guidance
  • Questionable management and majority owner motivations regarding tender offer and Artal share repurchase transaction
  • WTW stock has a short float of approx. 19% as of the time of writing

All of the above would suggest that WTW's common equity is highly risky with little margin of safety given the uncertain future and significant debt. On this basis, it would appear to fall within Dr. Michael Burry's definition of an "ick" stock.

3 Key Areas of Concern

In light of current market perception and consensus view for WTW, an investment analysis of WTW should focus on the following 3 key areas of concern:

  1. Business Prospects
  2. Financial Position
  3. Management & Ownership

Investment Consideration #1 - Business Prospects

The bear argument on WTW essentially revolves around the view that it now provides a stale product, operating on a permanently weakened business model, disrupted by the new competition from fitness apps and wearable fitness monitors. The most bearish extension of this line of thinking is that WTW is slowly becoming obsolete. While this argument appears to have some basis at least given recent industry trends and fundamental business performance, a number of points are relevant here:

Long-term financial performance

While the past is no guarantee of future performance, WTW's long-term track record indicates some degree of competitive advance in a fragmented industry marked by fads and consumer transience:

  • Steadily increasing revenues and free cash flow over the previous ten years
  • Consistent gross margins and EBIT margins (10-year average 55.4% and 28.1% respectively)
  • Very strong and consistent returns on invested capital (10-year average 40%, inclusive of operating leases)

Each of the above financial measures indicates the existence of a competitive advance or economic moat in Buffett parlance. This is attributable to the well established brand built by WTW over the last 50 years. The key question here is whether this moat is a durable one in the context of recent popularity of free apps and fitness monitors.

WTW's previous experience and the faddish nature of the industry itself would suggest that it is durable:

  • In 2003-2005, low carbohydrate diets, such as Atkins and South Beach gained in popularity and media exposure, resulting in quarterly attendance declines of up to 16.7% YoY in WTW's US business, and overall EBIT decline of 4% due to the "low carb" diet phenomenon
  • The fad diet phenomenon didn't last however; Atkins Nutritionals Inc., the company behind the Atkins diet business went bankrupt in 2005, as the purported effectiveness of these diets was questionable
  • By contrast, WTW remained focused on its core business, producing new weight plans and products, as well as developing its online platform (WW.com revenues in FY05 were $109 million with 535,000 active subscribers, versus 1.7 million subscribers and $522 million in FY13) - WTW went on to increase revenues and EBIT by 27% and 44% respectively by 2007 versus 2005, before the global financial crisis hit in 2008
  • The difficult economic environment arising out of the global financial crisis hit WTW revenues and EBIT in FY08-FY10, severely impacting consumer spending on weight management products. The Company again grew in FY11 and FY12 due to refreshed programmes and effective marketing campaigns, before the present challenge from free apps and fitness monitors gained momentum in FY13, resulting in the recent declines in revenues and earnings

One of the key reasons why low carb diets were proven to be a fad was they were ineffective - consumers did not achieve lasting results from following their programmes. By contrast, WTW's weight management plans and services have been proven to work, supported by clinical studies - hence the Company's post-2005 resurgence. The core fundamentals of the WTW weight management system do not change, only the presentation and communication does, via refreshing of programmes and plans and updated marketing. But there is another key ingredient to WTW's product offering that differentiates it from fad diets, and from free apps and fitness monitors - the habit and behaviour component of its system.

Product offering vs. App/Monitor competition

WTW's system focuses on behaviour modification through group support rather than do-it-yourself weight loss. Successful and enduring weight loss is achieved through a permanent change in a person's behaviour and habits, both in terms of consumption and lifestyle. Under the WTW programme this key component for weight loss is conveyed through the group meeting format, with motivation, support and guidance available from both other meeting members and the leaders, who are the living proof of the programme's effectiveness. By contrast, fad diets and more recently free apps and fitness monitors tend to be followed or utilised by individuals alone. This is a key differentiator for WTW versus its emerging competition.

Most competing products (diet pills, fad diet plans, and now free apps and fitness monitors) promise or create the expectation of unrealistic results within a short time frame, and are pitched as quick fix solutions to weight issues. Generally, they do not deliver promised results however, as they do not address the underlying reasons for weight problems, which tend to be rooted in behaviour . Changing unhealthy eating habits and lifestyles takes time, and there is no quick fix app or diet pill that can do this in a matter of weeks. Using a fitness app to track calorie consumption or a fitness monitor to track your jogging distance and calorie burn rate is helpful as part of a weight loss routine, but these elements by themselves will not deliver lasting weight loss for one simple reason - they require extraordinary self-discipline over an extended period of time in order to work. When it comes to fitness and weight management however, the vast majority of humans have a tendency to expect results from following various diets or regimens after an unrealistically short time frame, and then give up when desired results do not materialise, lacking the self-discipline to persevere. This is part of human nature, and particularly so now in the wirelessInternet age, with attention spans becoming shorter with mobile computing and the social media revolution. Therefore to bring about a change in habits or routine requires an extended and externally guided period of self-discipline. This is most effectively achieved in a supportive group environment. This is why WTW's service has been clinically proven to work.

I believe the following gym analogy perhaps best captures why WTW's group support format has proven to be so successful over the last 50 years. Much like someone going to the gym and lifting weights on a the bench press, it is more difficult for someone to push themselves to maximum effort by themselves - it is easier to complete a routine of exercises when with a friend or colleague alongside you, as the other person encourages you and pushes you to finish a routine, as well as perhaps stimulating competition when one sees that person finishes their own routine. Similarly, with the WTW system, when a member is part of a group or community of people who are all pursuing the same goal, are encouraging each to reach that goal, and are motivated by an accessible leader who has already successfully achieved that same goal, it is more likely that the member will achieve push on to achieve that goal themselves. The community habit approach is therefore a key component for successful and lasting weight loss that free apps and fitness monitors by themselves cannot offer.

Additionally, the WTW's system imposes self-discipline in a more realistic way for people, as it does not completely eliminate certain food types considered as contributory to weight problems. It PointsPlus system allows for the consumption of pizza for example, so long as the member has sufficient points left, which depends on what else they have eaten in a given day. Therefore if a member has been following their plan and consuming healthier, nutritional foods, which carry lower points values, i.e. they have modified their eating habits, then they are able to enjoy those less healthy but tasty alternatives every so often, without compromising their weight-loss goal. WTW's programme effectively systemises a balanced diet and moderation of consumption behaviour in an easy to follow and realistically achievable framework for members. This framework, communicated and reinforced by the group support format is why the WTW offering works.

By contrast, it appears unlikely that free apps or fitness monitors over time will supplant WTW's system. While they will certainly prove effective for some people who possess strong self-discipline, this speaks more towards people who already have some level of basic fitness that they wish to maintain. By contrast, people with real weight problems tend to have poor habits that have become ingrained over time and which can take longer to modify. According to WTW management, online subscribers typically stayed members for 9 months during FY13, which is significantly longer than most people stay engaged with an app, which is reckoned to be as little as 1-2 weeks. Given the recent explosion of free apps and wearable technology, I believe the last 12 months has seen the mass trialling of these "hot, new things" by consumers, rather than a paradigm shift towards a new model for weight loss.

Consumers have become distracted in the short term, but this will subside in the medium-to-longer term however as consumers become bored with the latest app or fitness gadget and realise that they are ineffective by themselves without extended engagement with a weight management routine that modifies their behaviour. This is borne out by recent research. According to Marketdata, weight loss and fitness apps should lose momentum in 2014, as dieters recognize that these devices can do only so much to motivate them and keep them on track.

Pricing

A common perceived flaw in WTW's business model is its economics - why would consumers be willing to pay a premium (by comparison) to subscribe to WTW's programme, when there are a multitude of free apps and one-off cost fitness monitors now available? Despite the recent financial crisis and consequent hit to consumer spending, and the free apps phenomenon, WTW's pricing does not appear to have been impacted:

Over the last five years, meeting revenues andInternet revenues per paid week have increased at 2.4% and 0.3% respectively, suggesting that while volumes in terms of overall paid weeks and attendances have declined recently, WTW's pricing model remains sound. The volume decline is attributable to the noise of the "hot new things" of apps and fitness trackers being trialled by consumers, but this should be short-lived. The fact that WTW has not reduced its pricing in the ultimate race to the bottom promoted by free apps is a positive in the medium and long term, as price cuts for its service have not set a precedent that would be difficult to reverse. As management turns the business around and the hype around free apps and wearable technology subsides, WTW subscription volumes should pick up again at the same level of pricing as before.

Another important point to note with regard to pricing is that members who join WTW's service are generally people who have tried various diets, pills and gym memberships with little success, and are willing to pay because they know it works, as borne out by the example of its leaders and the clinical evidence. Furthermore, consumers who have successfully lost weight in the past, but who have subsequently gained weight again (e.g. as a result of pregnancy) return to the programme because they know that it works, and are willing to pay again for the proven service.

Brand power

WTW is the most established and internationally recognised weight loss brand, and is synonymous with safe, healthy and effective weight loss. As such the Company has real brand value, as evidenced by the licensing of its brand to food manufacturers such as Kraft, General Mills and Parmalat for example. There is high awareness of the Company's brand among consumers given its clinically proven offering and safe weight management plans. Consumers trust the brand, knowing that unlike diet pills, meal replacements or fad diets which promote the exclusion of certain foods (to extremity in some cases), there are no potential adverse health or regulatory risks around its products or services. Furthermore, the accessibility of meeting leaders and the support network resonates with weight conscious people, reinforcing consumer trust in the brand. Additionally, given its effectiveness and brand value, WTW is able to attract recurring revenues from previous members, who return to using its products and services due to the positive previous experience and results achieved.

Business Opportunity

An important consideration in assessing WTW's future business prospects is the significant business opportunity presented by the wider obesity epidemic and the implications of this for businesses and other organisations. Obesity and related conditions such as diabetes and cardiac issues have steadily driven costs higher for businesses, health insurance providers, employers and private individuals - according to the Journal of Health Economics, obesity increases annual medical costs by $2,741 per adult. Clinical research also has found that obesity is the largest preventable condition driving increased healthcare costs in the US. Therefore the obesity epidemic places additional strain on the public health systems of numerous economies globally at a time of significant economic challenges including little or no economic growth, high unemployment and austerity measures. In light of this, there is a growing governmental and regulatory emphasis in many countries on preventing obesity and related conditions as part of healthcare reform initiatives.

WTW has established a specialist division, Weight Watchers Health Solutions, to specifically capitalise on this trend. There is a particular opportunity in the business-to-business (B2B) segment, with many corporates now implementing employee wellness initiatives to reduce the cost of ill-health among staff. WWHS is well positioned to serve this opportunity, thanks to its long-established brand, clinically proven offering, and also given that it has an existing foothold in 200+ blue chip corporate clients, including Google Inc., and Dow Chemical for example.

WTW currently generates $75m in revenue from WWHS, but estimates that this could increase to $300m - $500m by 2018 (a CAGR of 41% - 60%). A 2013 survey of corporate wellness decision makers in the US recently indicated how well positioned WTW is with regard to this opportunity, with 58% of respondents indicating that WTW was their preferred weight loss programme - Jenny Craig was the nearest competitor with just 7%. Respondents indicated WTW was the preferred choice as it was already popular among employees, teaches lifestyle change, had the best reputation and it works, among other reasons. This is a clear testament to the strength of WTW's brand. Interestingly, the highest ranking free app product was MyFitnessPal, which just 2% of respondents preferred.

There is a clear, high growth opportunity for WTW here, but key to developing this will be effective and appropriate investment to ensure regulatory (HIPAA) compliance, systems, data capture and personnel.

In summary, I believe WTW's business mode remains valid that it has excellent future prospects given the following:

  • Consistent, long-term financial performance despite numerous fads and fragmented marketplace
  • Valid product offering that addresses the underlying issue behind weight problems and obesity - habit and behaviour modification
  • Pricing power enabled by strong brand, consumer trust and product efficacy
  • High growth business opportunity in corporate wellness and healthcare reform initiatives

The above factors lead me to conclude that with sufficient stewardship from management, WTW can continue to be the world's leading commercial weight management company.

Investment Consideration# 2 - Financial Position

A key concern for prospective purchasers of WTW common stock is its financial position and specifically the level of financial risk inherent in the business at present, in the context of the recent deterioration in underlying business performance. Given the significant level of debt on WTW's balance sheet, any further deterioration in performance would have the effect of increasing effective leverage to the detriment of equity value. In this context, the key concern for a prospective investor in WTW common stock is if recent negative trends were to continue, would WTW struggle to service its debt and fall into bankruptcy, thereby ensuring permanent impairment of equity value?

Overview of current financial position:

As at 31 December 2013, WTW's total debt obligations were as follows:

Key terms of the debt include:

  • Base rate is LIBOR or a base rate at the option of the Company
  • WTW is not required to maintain any financial ratios e.g. net debt/EBITDA or EBITDA/Interest expense cover
  • Debt is senior secured, over all assets of the Company, and is guaranteed by certain existing and future subsidiaries
  • The Revolving Facility requires WTW to not exceed a specified Consolidated Leverage Ratio of 5:1, if borrowings under the Revolving Facility exceed 20.0% of revolving commitments (i.e. $50 million) at a quarter-end; at 31 December 2013, the maximum Consolidated Leverage Ratio was 5:1, while the actual Consolidated Leverage Ratio was 4.2:1, and balance outstanding on the Revolving Facility was nil

In February 2014, Moody's downgraded WTW's credit rating from Baa1 to B1, citing " Unexpectedly poor operating results in early 2014 - in particular, accelerating declines in meeting recruitment, paid weeks and attendance - will result in sharply reduced profits and cash flow this year, and raise financial leverage considerably ," adding that " Consumer demand for weight management is likely to be high and Weight Watchers is still the market leader, yet the company's strategy for regaining market share lost to new alternatives is uncertain ."

Furthermore, Moody's reiterated a negative outlook for WTW, stating " the negative ratings outlook reflects Moody's concern that evidence of business stabilization may not appear in 2014, which could imply further deterioration of financial leverage and cash flow. The ratings outlook could be stabilized if new products or marketing campaigns lead Moody's to expect meeting attendance, paid weeks andInternet revenues to bottom during 2014, leading to overall revenue and profit stability, resulting in debt to EBITDA of less than 6 times and free cash flow to debt of about 8%. A further downgrade to ratings is possible if Moody's expects meeting attendance, paid weeks andInternet revenues to continue to decline ."

While there are no financial covenants contained in WTW's facility agreements, Moody's rating commentary indicates that a debt/EBITDA ratio of less than 6x, and FCF/Debt yield of 8% would be sufficient to improve its outlook for the business.

Downside scenario analysis

Given the potential for financial distress based on current circumstances, it is necessary to consider a realistic downside scenario for future performance, in order to assess the potential risk of bankruptcy and permanent impairment of capital. In determining an appropriate downside scenario, one must begin with management guidance for FY14 based on the year-end earnings call, which indicated:

  • Management expect FY14 to be a challenging year with a continuation of the negative trends experienced in Q4 of FY13
  • Revenues to decline to $1.4 billion (vs. $1.7 billion reported in FY13 - a 16% decline YoY)
  • Gross margin contraction of 400 bps to 54% vs. 58% in FY13
  • General and Admin (G&A) Cost-savings of approx. $90million to be delivered in FY14, under $150 million annualised cost-saving programme begun in FY13
  • G&A expenses to decline in low single digit %
  • Interest expense of $125 million (vs. $103 million in FY13)
  • Capex of $50 million

Factoring the above, I estimate the following downside scenario for revenues, free cash flow and debt servicing for the five-year period from FY14 - FY18:

(click to enlarge)

The above analysis assumes the following:

  1. Meetings revenues decline 10.2% per annum over five-year projected period, being extrapolation of FY13 YoY decline rate
  2. Internet revenues increase at 1.7% per annum over five-year projected period, being the FY13 YoY increase rate
  3. Product sales decline in line with meetings revenues at 10.2% per annum
  4. Franchise revenues increase at 0.8% per annum, based on last 5 years CAGR in franchise revenues as WTW continues to acquire franchises strategically
  5. Gross margin contraction of 400 bps expected for FY14 is not reversed in subsequent years
  6. Opex declines at low single digit rate of 3%, per management guidance
  7. Only $30m of G&A cost saving are achieved, vs. management estimate of $90m
  8. D&A assumed in line with FY13 rate, at 3% of revenues
  9. Movement in working capital estimated at 10.5% of revenue, being average of last five years; reduction in working capital arises due to declining revenue projected
  10. Capex of $50m in FY14 per management guidance, and at 3.9% of revenues thereafter, in line with trailing 3-year average, reflecting continuation of increased software and technology platform investment
  11. Interest expense of $125m in FY14 per management guidance, followed by significant increase in annual cost of debt to 7% from FY15 onwards (vs. 4.45% total effective cost of debt in FY13)
  12. Capital repayments assumed to be made at 50% of FCF after interest payment

Note: FCF analysis of WTW is frequently calculated as Operating Cash Flow ((OCF)) - capex - capitalised software expenditure as - this is incorrect. OCF per WTW's reported cash flow statement includes interest expense , which is already reflected in the opening net income line on the cash flow statement. As such, FCF on this basis includes partial debt servicing, and does not fully reflect the free cash generation of the business before returns to debt or equity, i.e. Free Cash flow to the Firm ((FCFF)), which is the free cash available to management to make distributions to all capital stakeholders, debt or equity. Therefore the correct calculation for FCF in this instance is to add back interest expense per the income statement to OCF before subtracting capex (which should include capitalised software expenditures). This has the impact of "increasing" FCF for FY13 from $262m to $364m, based on WTW's cash flow statement reporting.

The above analysis presents a realistic worst-case scenario for WTW, extrapolating the recent negative trends in WTW's meetings andInternet business segments out over the next 5 years. Based on this analysis, I conclude the following:

  • Given the positive outlook for the weight management industry in the years ahead, WTW's consistent track record of earnings power and cash generation over the last 10 years, its strong international brand and turnaround initiatives now being undertaken by management (see Management & Ownership section below), I believe the probability of recent negative trends persisting as projected is extremely low
  • Even if these trends were to persist, the worst-case analysis (based on very pessimistic assumptions) indicates that WTW would have the capacity to service its debt obligations (both interest and capital), even after a significant increase in interest rates persisting from FY15 onwards
  • While credit metrics such as debt/EBITDA would deteriorate further, WTW is not bound by any such financial covenants under its facility agreements and would therefore not breach any of its loan terms
  • On the basis of the above worst-case downside scenario analysis, WTW would not fall into bankruptcy, and therefore equity value may be challenged, but not permanently impaired over a 5-year time investment horizon

Investment Consideration #3 - Management & Ownership

The two areas of concern for prospective equity investors with regard to WTW management and ownership are (1) Management competence and integrity, and their ability to deliver a turnaround in performance, and (2) motivations of management and majority owner Artal.

Management Competence

At the November 2013 Investor Day event and the FY13 earnings call in February of this year, WTW management delivered an honest assessment of the Company and why performance has deteriorated, and articulated a clear turnaround plan to stabilise the business and return to growth.

CEO James Chambers summarised the Company's current situation as follows:

  1. WTW offering has become less appealing in a changing market, as WTW's product and service innovation approach has not been sufficiently market driven. Additionally, management needs to modernise WTW's technology platform and create a more efficient product development engine
  2. Secondly, costs have increased over time, and management did not react sufficiently to flex these costs as recruitment trends turned negative recently in a changing market
  3. The Company still possesses a number of strengths, specifically the efficacy of its programme, trusted and recognised brand and large community of past and present members that can be leveraged

I believe the above summary is a fair assessment of where the Company is at present, and believe management is now fully aware of the challenges facing the business and what needs to be done to improve performance.

More specifically, the recent underperformance can be specifically attributed to the following factors:

  • WTW underestimated the competitive threat of mobile technology and underinvested in its technology platform
  • Low level of innovation in meetings business offering
  • Disenfranchisement among meeting leader community (low wages and commission rates, little meeting set-up support, therefore low incentivisation leading to drop off in member attendances)
  • Not market focused, with product and service offering not addressing changing consumer preferences (convenience, delivery methods, personalisation of plans etc.)
  • Ineffective marketing campaigns resulting in WTW's message being lost amid hype of free apps, and other weight management trends
  • Costs creeping upwards

What is notable is that while these factors are all product of management shortcomings, each one of these flaws is fixable - the WW.com website and online resources can be improved, relations with and remuneration levels for leaders can be improved, more effective marketing and consumer engagement can be implemented and costs can be controlled. None of these factors constitute permanent flaws or defects in the Company's business model. Management could be charged with past complacency, but I do not believe the prospects of the business are permanently impaired as a result of these factors.

Management Integrity

With regard to management compensation, total named executive officer remuneration per the latest proxy filing does not appear excessive:

Note the above amounts include basic salary, bonus, stock and option awards, incentive plan compensation, pension and other contributions.

Regarding capital allocation, while the 2012 tender offer and Artal share purchase transaction at a price of $82 per share in 2012 certainly destroyed shareholder value and constituted a poor allocation of capital, the then CEO and CFO who presided over this have since left the Company and been replaced by two well qualified replacements with significant, relevant industry experience. James Chambers held senior positions with Kraft Foods (a WTW licensee) prior to joining WTW as CEO in July 2013, and Nicholas Hotchkin held a senior finance role with Staples Inc., the global office supply business. While the tender offer and Artal share purchase are now the subjects of a class action lawsuit, in which Chambers and Kirchnoff are named as defendants, it is important to note that they are named simply on the basis that they are current senior management executives at the Company. They were not employed by WTW at the time of these transactions, nor did they profit from any exercise of options or sale of common stock under the transaction as their predecessors did.

Turnaround Plan

To address the recent underperformance, management announced a "Four Pillar" turnaround plan, comprising the following strategic aims:

  1. Drive immediate performance improvement - addressing the immediate concerns for the business by focusing on maximising member activations through improved and more focused advertising, while implementing tighter cost management, including $150m annualised cost savings
  2. Re-imagine the core offering - new product offering tailored to consumer preferences through listening more to consumer's needs, including greater personalisation of weight loss goals, and easier to use and understand offering for new or prospective members
  3. Grow the healthcare business - key potential growth driver for the key US business, with growing concerns about obesity creating significantly higher costs for employers, health plans and healthcare providers. WTW is well positioned to serve this market with existing foothold in corporate market (200+ customers), and will look to partner with more businesses and health plans to offer WTW programme as part of health benefits offering. Management has also identified the key areas of investment required to fully serve this market opportunity, including dedicated healthcare team, regulatory compliance costs, data capture and systems
  4. Strengthen the organisation - a service business is only as good as its people, and WTW has recognised this by recruiting new people in key positions such as Chief Technology Officer, and Human Resources. Additional areas identified for strengthening include better compensation of meeting leaders, and improved operational efficiency

Management has made early progress in implementing the turnaround plan, with cost savings of $60m achieved in FY13. The output of this turnaround plan is that while FY14 is expected to be a challenging year for WTW, management believe that the implementation of the plan will positively impact member recruitment by 2015, with revenues targeted to be in excess of $2 billion by 2018 (16% ahead of FY13, and 43% ahead of forecast revenues for FY14 - not explosive, but realistic growth targets).

Management is fully aware of the current challenges facing the business, have honestly appraised past mistakes and shortcomings, and have a clear plan to turn the business around. On this basis, I believe WTW's current management team are able, competent and honest.

Ownership

One area of potential concern is the lack of significant insider ownership, with management owning approx. just 0.2% of the Company's common stock. In the context of management's pronouncements on turning around the business (see below), its strengths and prospects it will be interesting to see whether management will increase their shareholdings in due course.

Additionally, WTW's $779m purchase of Artal stock in 2012 raises the question of whether Artal's interests as controlling shareholder (52% post 2012 transaction) conflict with those of other shareholders. Artal's CEO Raymond Debanne is also the Chairman of WTW, a position held since Artal's LBO of WTW in 1999. In this context, WTW is an unusual proposition for investors, in that it is effectively a publicly listed LBO company. The concern for prospective investors here is that it appears Artal as majority owners instigated a transaction that released cash from the business primarily for their benefit, forcing WTW to incur excessively high levels of debt, precipitating a sharp decline in value for other shareholders. While Artal's 52% shareholding was also adversely impacted, historical context is important here:

  • Artal acquired WTW in 1999 in an LBO worth $735m, of which $224m was financed by Artal equity
  • Since 1999, Artal has received a total of $3.8 billion in proceeds from WTW via dividends, share sales and the sale of WW.com to WTW in 2005 (WW.com was previously held separately to WTW by Artal), representing a return for Artal to date of 17x its money, while still retaining a 52% shareholding, today valued at approx. $600 million

On this basis, one could argue that since its 52% has been effectively a free carry in WTW for a number of years, the impairment of value is negligible to Artal at this stage, in the overall context of returns to date. Extending this view leads to the question of Artal's level of commitment to WTW should performance deteriorate further and WTW becomes distressed. Artal could respond to a further deterioration in WTW's performance and value in one of three ways:

  1. Allow WTW to collapse into bankruptcy
  2. Continue to support the business, via equity injection or emergency credit facilities if required (potentially dilutive to other shareholders)
  3. Take WTW private by acquiring 48% it does not own at a premium to current price

I do not believe Artal would allow Scenario 1, bankruptcy, to materialise for two reasons:

  1. WTW remains the largest position in Artal's portfolio (55%), even at current prices
  2. As an investment, WTW has been exceptionally and consistently lucrative for Artal, and therefore it is in their interests to preserve the value of their shareholding

Therefore, it is highly unlikely that Artal would allow WTW to fail in my view.

Scenario 2 would likely involve significant dilution for existing shareholders, through a rights issue or other form of equity solution, e.g. preferred equity. However, the worst-case scenario analysis above indicates that WTW is unlikely to approach a bankruptcy scenario in the next five years.

Scenario 3 would allow Artal to acquire WTW outright at a depressed price (versus history) and realise further value again in the future should WTW successfully turnaround, essentially repeating its previous, highly lucrative investment cycle with WTW all over again.

On the basis of the above, I do not believe Artal's ownership presents a risk to current or prospective investors in WTW common stock.

Valuation Analysis

To estimate the intrinsic value of WTW, I estimate earnings over the next 5 years (FY14-FY18) under 3 potential scenarios:

  1. Base case - reflecting recent management guidance for F14, with modest improvement thereafter
  2. Worst case - reflecting recent management guidance for FY14, with extrapolation of recent adverse trends into the future, which assumes management does not deliver on its turnaround plan. This is the downside scenario outlined above in the Investment Considerations section
  3. Best case - reflects recent management guidance with FY14, with a gradual return to historical growth rates thereafter, reaching management's turnaround plan target revenues of $2 billion in 2018

In each scenario, I apply what I believe to be very conservative assumptions in arriving at estimates of future earnings power under those scenario conditions. It should be noted that these estimates are not intended to be predictions, as the future is inherently unknowable. Rather, this scenario analysis serves to inform a realistic assessment of future outcomes for the business.

I believe an EV/FCF multiple is the most appropriate valuation methodology for WTW, given its consistent track record of free cash generation.

As noted above in the Investment Considerations section on financial position, FCF analysis of WTW frequently calculates FCF as OCF - capex - capitalised software expenditure, which is incorrect, as OCF per WTW's reported cash flow statement includes interest expense , which is already reflected in the opening net income line on the cash flow statement. The valuation analysis calculates FCF by correctly adding back interest expense to OCF in order arrive at true free cash generation to the firm from all sources of capital, i.e. debt and equity.

Scenario 1 - Base Case

(click to enlarge)

Base case scenario assumes the following:

  1. FY13 results presented above are actual
  2. Revenues decline to $1.4 bn in FY14 as per recent management guidance, but grow at CAGR of 5.4% from FY15 - FY18
  3. Gross margin contraction of 400 bps in FY14 and FY15, before mean reverting to trailing 5-year average of 56.1% from FY16 - FY18
  4. Opex declines at low single digit rate of 3% in FY14 as per management guidance and before G&A savings
  5. $90m of G&A cost savings are achieved in FY14 as per turnaround plan; opex reverts to trailing 5-year average % of revenues at 29.7% from FY15 onwards
  6. D&A assumed in line with FY13 rate, at 3% of revenues
  7. Movement in working capital estimated at 10.5% of revenue, being average of last five years and applied to estimated YoY change in revenue
  8. Capex of $50m in FY14 per management guidance, and at 3.9% of revenues thereafter, in line with trailing 3-year average, reflecting continuation of increased software and technology platform investment
  9. Interest expense of $125m in FY14 per management guidance, followed by increased average cost of debt to 5.5% thereafter (vs. 4.45% total effective cost of debt in FY13)
  10. Capital repayments assumed to be made at 50% of FCF after interest payment, implying total debt paydown of $397m over 5-year period

Scenario 2 - Worst case

As outlined in Investment Consideration #2 - Financial Position analysis above:

(click to enlarge)

Refer to above section for assumptions.

Scenario 3 - Best case

Best case scenario assumes the following:

  1. FY13 results presented above are actual
  2. Revenues decline to $1.4 bn in FY14 as per recent management guidance, but grow at CAGR of 8.5% from FY15 - FY18 reflecting quicker return to growth from increased enrolments off of trough level in FY14
  3. Gross margin contraction of 400 bps in FY14, before mean reverting to trailing 5-year average of 56.1% from FY15 - FY18
  4. Opex declines at low single digit rate of 3% in FY14 as per management guidance and before G&A savings
  5. $90m of G&A cost savings are achieved in FY14 as per turnaround plan; opex reverts to trailing 5-year average % of revenues at 29.7%
  6. D&A assumed in line with FY13 rate, at 3% of revenues
  7. Movement in working capital estimated at 10.5% of revenue, being average of last five years and applied to estimated YoY change in revenue
  8. Capex of $50m in FY14 per management guidance, and at 3.9% of revenues thereafter, in line with trailing 3-year average, reflecting continuation of increased software and technology platform investment
  9. Interest expense of $125m in FY14 per management guidance, followed by increased average cost of debt to 5.0% thereafter (vs. 4.45% total effective cost of debt in FY13) - assumes WTW is able to maintain relatively low cost of debt as capital is repaid
  10. Capital repayments assumed to be made at 50% of FCF after interest payment, implying total debt paydown of $451m over 5-year period

Rationalisation of FCF estimates

As a sense check of the above FCF estimates, it is useful to compare them to the actual lows for FCF reported during the preceding 5 and 10-year periods, as follows:

As the above chart indicates the estimates of FCF under the base and best-case scenarios fall around the low end of WTW's historic free cash flow. Furthermore, the worst-case scenario indicates free cash generation significantly below the business's historic FCF low point. On this basis, I conclude that each of the scenarios considered are extremely conservative in their assumptions, particularly in the context of favourable business prospects and management delivering on the turnaround plan.

WTW Valuation

At the current share price of $20.04, WTW has a total market capitalisation of $1.13 bn, which implies a current EV/FCF multiple of 9.2x. This suggests undervaluation compared to both WTW's historic EV/FCF multiple and the current multiples assigned by the market to comparable quoted peer companies, as follows:

The market has valued WTW at an average EV/FCF multiple of approx. 15x over the last 10 years, while the average multiple currently assigned to comparable peers NTRI, MED and HLF is 11.6x (Source - author calculation based on individual company filings, Google Finance). However, this is distorted by the recent sharp decline in HLF's share price upon the announcement of a criminal investigation by the US Department of Justice and the FBI into its practices.

I believe that an EV/FCF multiple of 15x is most appropriate for valuing WTW, given:

  • Its scale and brand advantages over peers,
  • Its long-term track record of consistent free cash generation and high returns on capital (10-year average of 40%); and
  • Long-term valuation multiple of 15x

Applying a 15x multiple to FCF under base, worst and best-case scenarios, I estimate the intrinsic value of WTW to be $1.9 bn, or approx. $33 per share on a fully diluted basis, representing 65% upside from the current share price:

Assumptions:

  1. FCF is before any debt servicing costs (interest or capital) under each scenario
  2. Total corporate debt as reported at December 2013 year-end
  3. Given that WTW leases a significant amount of venues for its meetings businesses, this is effectively a form of off-balance sheet financing, required to generate the cash-flows from its meetings business; therefore this is treated as junior ranking debt in arriving at equity value
  4. WTW has a negative working capital cycle, where members pay subscription fees monthly in advance, while the Company has credit terms with creditors. While the Company has cash and equivalents of $174m at 2013 year-end, it had average negative current liabilities (excluding cash and interest-bearing debt balances) of $180m for the year. On this basis, for additional conservatism, I assume that there is no excess cash, and a $5m cash deficit arising would have to be funded by a prospective acquirer in a full acquisition of the business. Therefore I adjust for this in arriving at equity value.
  5. Adjustment for debt paydown over 5 years is assumed on the basis of WTW continuing to meet its debt obligations, using 50% of FCF (after interest expense) to repay its debt over the next 5 years. In each scenario, any paydown of debt while the business continues to generate free cash flow in future years will create value for the equity holders.
  6. While the worst-case scenario would result in a permanent impairment of capital of approx. 72% based on the current market value of the business, I believe the probability of this scenario occurring is extremely low, at 10%. I assign a 30% probability to the best-case scenario, and a 60% probability to the base-case scenario, on the assumption that management will deliver on its turnaround plan and continue to service the Company's debt, thereby creating value for equity over time
  7. 65% upside to the current price equates to an annualised return of 13% over the next 5 years. However, given the conservatism of FCF estimates under the 3 scenarios versus WTW's historic cash generation, any accelerated paydown of debt achievable under the base and best-case scenarios (which I believe is quite plausible) would increase this to a 15%+ annualised return

Risks

I believe the following are the key risks to investment in the common equity of WTW:

Risk

Risk Mitigant

Continuation of negative recruitment trends and further deterioration in performance

New management has clearly and honestly identified issues facing the business and are implementing a turnaround plan. Additionally WTW has a strong brand and consistent track record in an industry marked by fads. On this basis, it is unlikely its offering will become obsolete if management successfully implements the turnaround plan

Financial risk due to excessive debt raised in 2012 impairing equity value and forcing bankruptcy

Business has a consistently strong cash generation profile, even with recent negative trends ($364m in FY13) and management is imposing renewed cost discipline as part of a turnaround plan, which should allow the Company to continue to meet debt obligations

Adverse actions by majority owner Artal

WTW is Artal's largest position in its private equity portfolio (c. 55%) and has been a very lucrative investment -it is in Artal's interest to oversee turnaround and support new management to preserve and grow value. On this basis, its interests appear to be aligned with other common shareholders

Management is unable to implement turnaround due to changing market (free apps or other fads reducing further the appeal of WTW) or incompetence

New CEO and CFO are experienced executives having held senior roles in other publicly-listed companies. Management has honestly identified the shortcomings in the business and its product/service offering, developed a clear turnaround plan and have successfully achieved cost saving targets in FY13. On this basis, WTW appears to be in capable hands

Notes & Sources:

  • All financial information for WTW has been sourced from Company filings (Forms 10-K, 10-Q and DEF14A for the historical periods presented) made with the SEC
  • All charts and graphical analysis has been prepared by the author, IndependentValue, using information disclosed in the Company's SEC filings unless otherwise stated.
  • All forward-looking financial projections and estimates have been prepared by the author using proprietary analysis

Disclosure: I am long WTW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

See also Tesla: Strong Quarter, But Investors Feel Like They Need More Details on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: NTRI , MED , HLF , KRFT , WTW

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