Weight Watchers is a branded, global provider of weight-loss services operating in over 30 countries worldwide. At the center of the company's weight-loss program are weekly meetings in which members are educated on safe, effective, weight loss and encouraged by classroom leaders and other members. Weight Watchers conducts its business through both company owned and franchise operations.
Weight Watchers Business Strategy
There are three key components to the company's weight loss program: group support offered in the classroom setting, diet and exercise. The Company's approach involves the use of POINTS, which are assigned to different food products, which in turn should help the individual to achieve a healthy diet. Weight Watchers' program is distinctive in the marketplace in that it focuses on education and behavior modification for successful weight loss. The Company also endorses its own food line (together with Heinz Foods), a magazine, cookbooks, and a website. Revenues are derived primarily from fees charged at the weekly meetings, though a growing portion of revenue is generated from branded product sales. The firm is a service type business model in which substantial revenues are produced by a relatively small asset base.
According to the 1999 National Health and Nutrition Examination survey (NHANES), obesity affects 27% of adults in the US, or roughly 50 million people. In addition, NHANES estimates that 35% of the population (63 million adults) are overweight and in need of weight loss. These numbers are expected to increase in the coming years, as people are affected at an increasingly younger age.
Weight Watchers operates in a competitive market. The Company competes not only against other commercial weight-loss programs but also against meal-replacement products, 'fat burning' pills, also medical/ surgical solutions. On the pharmaceutical side, several weight loss drugs have come to market in the past decade and there are several under development. However, these recent products have shown limited efficacy and have elicited safety and tolerability concerns. On the diets side, low carb diets such as Atkins and South Beach have enjoyed considerable popularity. Management feels that these diets are simply a fad and unlikely to remain as long term competitors. Pills and diets simply do not promote the sort of lifestyle changes necessary for sustained weight loss. We feel that the management's beliefs are supported considering the fact that the company has been around for over 40 years and has seen many different types of diets/pills come and go while it continues to grow.
The main issues which we have identified involve their purchase of franchisees and their treatment of their subsidiaries.
First, the company has made a number of purchases of franchisees over the last couple of years. They consolidated the operations of these companies into their financial statements and have recorded the excess of the purchase price over the fair market value of the assets as either goodwill or an intangible asset. As of September 27, 2003, the company has $464 Million of franchise rights acquired, $24 Million worth of Goodwill and $2.4 Million of other intangible assets recorded on their balance sheet. These three intangibles account for close to 66% of the total assets of the company.
According to GAAP, the company must assess the value of these intangibles and only write them down if they are impaired. We are skeptical of the company's ability to achieve liquidity for these intangibles and therefore, we are unsure as to what the proper value of these assets should be. Any company that has such a large portion of their assets in intangibles must be closely monitored, as the write down of these assets will have a significant impact on their net income and all associated ratios.
The second issue of concern is the performance of unconsolidated franchisees. The only disclosure the Company makes regarding these franchisees is the royalty payments which are approximately equal to 10% of the meeting fees for the franchises. This information is helpful but without accompanying expense data we can not monitor the profitability of the franchises. This risk is mitigated by the fact that Weight Watchers no longer sells franchise rights and has been steadily repurchasing franchises. Management has stated that it originally embraced franchising to achieve rapid market penetration; with that achieved it is now repurchasing the franchises to drive profitability.
An additional mitigating factor is evident in their treatment of WeightWatchers.com, which is a subsidiary that is not currently consolidated. The company has a loan outstanding to the subsidiary, and the sub has been losing money. Weight Watchers has decreased its equity investment by the losses of the subsidiary and they have also written off most of the loan due from the sub. Therefore, we have reason to believe that it is closely monitoring the profitability and collectibility of its receivables from the unconsolidated subs and franchisees.
Finally, when the firm went public it did so as part of a tax free restructuring that generated a $144 Million DTA. This DTA represents approximately 15% of Total Assets and is being amortized away on what appears to be a 10 year schedule. This brings Intangible Assets to approximately 80% of the Total Assets. Therefore any ratios or analysis that relies on the value of Assets is subject to question.
When we originally decided to do a financial analysis of Weight Watchers, we figured that we would do some ratio analysis of the company compared to both their main competitors and past trends. The problem which we came across was the fact that they do not currently have any pure competitors. As we mentioned earlier in the competitor analysis, there are some companies that compete on some of the business lines, yet no-one else presents the complete package like Weight Watchers. Therefore, we did not feel that a regular ratio analysis compared to competitors would be useful.
We then attempted to take a broader definition of the industry that they compete in. We concluded that they are a service company that somewhat competes in the consumer products industry. Some analysts have attempted to Weight Watchers to Colgate, Gillette, Kimberly Clark and Procter & Gamble. We again do not believe that these are strong comparable companies, as most of these companies have large asset bases and will produce very misleading ratios compared to Weight Watchers.
Another problem with ratio analysis involves the fact that Weight Watchers have only been a public company since 2001. There is not enough past results available to look at trends with regards to their ratios. Detailed historical ratio information as well as forecasted ratios are contained in Exhibit 4 below. One ratio that is worth examining in further detail is the company's return on equity (ROE). According to the 2002 figures, the company has a ROE of -428%. We suspect that this is the reason the stock originally was screened as a "overvalued" security. The large negative balance stems from the negative equity figure for Weight Watchers combined with the large net income. This is due mostly to the large amount of treasury stock that they currently have in their equity accounts at the end of 2001. According to our forecasts, the ROE will quickly turnaround in 2003 as Net Income drives equity to a positive value 148%.
Using the Dupont Model to further explore the source of the large ROE figure we find that the firm is extremely profitable, highly levered and asset efficient. Based on our forecast discussed below we believe this trend will continue in the future. The company has successfully generated large amounts of income from a relatively small asset base. Considering that Weight Watchers has not seen any form of pure competition in the past 40 years of existence, we do not anticipate them having to change their margins substantially to fend off competition over the forecasted future. Nor is there any impending need for massive investment in Assets in the foreseeable future. Therefore terminal ROE is forecast to 63.8%.
The firm has a significant amount of debt that results from its sale to Artal Luxemborg in 1999 as well as its recent acquisitions. It has an extremely high Debt to Equity ratio of 9.8/1. The default probability is lower than expected at 4.4% reflecting that even with this large amount of debt the company is not in danger of default. The low default probability is to its large positive earnings which provide plenty of interest coverage 7x.
Utilizing eVal software we projected financial statements with a 10-year time horizon before making terminal assumptions. It is worth noting that Weight Watchers though it has existed for 40 years has only been publicly traded for two years. This short time horizon limits data availability. Additionally the firm employed a strategy of early aggressive franchising to establish a broad market position and is now in the process of repurchasing the franchisees. We believe this selective repurchase strategy will continue which further complicates forecasting. All items on the "Forecasting Assumptions" tab were left at historical base lines with the following exceptions that are discussed in detail below: revenue, SG&A/Sales, Interest Expense/Avg Debt, Preferred Dividends/Avg Preferred Stock, Intangibles/Sales, Other Assets/Sales, Current Debt/Total Assets and LT Debt/Total Assets. Annual financial statement forecast data is summarized in Exhibit 3.
In order to project the revenue growth we analyzed the revenue sources and drivers of revenue growth. Currently the company's sales are derived from the following sources:
Meeting fees: The Company derives almost two thirds of its total revenue from domestic and international meeting fees or fees paid by members to attend weekly classes. Primary growth driver of this revenue category is number of people enrolled and attending Weight Watchers classes.
Product sales: Weight Watchers sells a line of proprietary products that complement its weight loss programs. The products include snack bars, books, CD-Roms, and POINTS calculators. Products are available primarily through company-operated classroom sessions. We believe that because of this distribution strategy, product sales revenue growth is also driven by member attendance rates. Weight Watchers does not advertise its products and relies on classroom session attendance for majority of its products sales.
Franchising commissions: The Company's franchisees typically pay the Company a fee equal to 10% of their meting fee revenue; therefore, it is reasonable to conclude that growth in franchise commissions as well as product sales and meeting fees is primarily driven by increase in attendance rates. We also predict that franchise commissions revenue will start declining due to the fact that the Company has been following active acquisition strategy in North America and stated that it does not plan to license any new franchisees and will continue selective acquisitions in the US.
Consistent with the above analysis, we have based our revenue growth projections on our estimates of attendance growth in different geographic regions.
North America: We have projected attendance growth of 8% in 2004 for North America gradually declining to 2.5% in 2013. We believe that 8% attendance growth is justified due to lower penetration of Weight Watchers in North America compared to UK (9% vs. 11.3%) and the Company's intention to grow through franchisee acquisitions in this region. By 2003, we believe that the growth in attendance will stabilize at 2.5% consistent with US population growth.
UK: UK attendance growth is predicted to be more moderate (3% in 2004 declining to 1% in 2013) due to Weight Watcher's high penetration rate in the UK market.
Continental Europe: Weight Watchers is present in many European countries (Sweden, Finland, Belgium, France, Switzerland, Netherlands, Germany, Denmark and Spain) and we see potential of high attendance growth rates in these countries due to low penetration rates in almost all of the Continental Europe. We have project attendance growing at 6% in 2004 and decreasing to 1% in 2013.
In addition, we have factored in increase of revenue per attendee by 3% annually to provide for inflation driven price increases.
Our revenue growth projections through year 2013 are presented in Exhibit 2. Year 2013 is considered a terminal year and revenue growth is assumed to stabilize at 5% from that point on.
We forecast this will decline modestly from 17.6% to 16% in 2003 due to management's short term goal of driving additional revenues without proportional investment in SG&A. Over the longer term though we suspect that the company will face increased competition and will need to spend more on advertising to protect its brand and market position. Therefore SG&A gradually increases to 18% of Sales in the Terminal Period.
Interest Expense/Average Debt
Late in 2003 the Company refinanced a substantial portion of its long term debt reducing its average interest rate from 9.1% to 3.7%. We forecast that Interest expense will remain at this low level through 2004 then begin a steady rise to 7% as approximately half of the firm's debt is variable rate.
Preferred Dividends/Average Preferred Stock
The Company repurchased all of its outstanding preferred securities in 2002 and as such no Preferred Dividends will be paid going forward.
The majority of Intangible Assets is assigned to Acquired Franchise Rights. In 2002 this was 38.4% however in 2003 several significant franchisee acquisitions have taken place according to the most recent 10Q. We expect no further acquisitions this year so we forecast this to be 53.4% of our projected full year Sales number. The amounts we plugged into eVal are: From 2003 to 2007 we allowed for approximately $50 Million p.a. increase in Intangibles as part of the selective franchisee acquisition strategy noted above. In 2007 we froze the level of Intangibles for the remainder of the forecast period assuming that the consolidation trend would be played out. Furthermore we assumed that these Intangible Assets will not become impaired and therefore no amortization will be taken on this goodwill.
This is primarily due to the Deferred Tax Asset created when the firm was sold by Heinz to Artal Luxemborg in a two step transaction that involved a tax free restructuring and acquisition in 1999. Based on historical data we assume this DTA is amortized over 10 years and Other Assets stabilizes in the terminal year at a value of 2% of Sales.
Current Debt/Total Assets and Long Term Debt/Total Assets
The Company refinanced substantially all of its debt in 2003. Using the schedule provided in the 10Q (reproduced below) we were able to forecast the exact amount of Current Debt and Long term Debt through to 2009 at which time all of the debt is due. Since we believe that the firm is essentially at or near its maximum attainable debt level and we assume that future acquisitions will be paid for entirely from Cash from Operations we can project Debt levels from the disclosed repayment schedule. The debt schedule from the 10Q is as follows:
Long-Term Debt Obligations
(Including Current Portion)
As of September 27, 2003
Remainder of 2003$7.7
From 2009 on we assume that the capital structure is set at approximately 35% debt to equity ratio (this translates to an 18% Debt/Assets ratio). This amount of debt reflects the debt load that we think the company can obtain without incurring inordinate bankruptcy probabilities.
Further analysis of these forecasts in the form of yearly ratio analysis is provided below in Exhibit 4. As reflected in the ratio projections we believe the firm will continue to generate large amounts of free cash flow which it can use to further reduce debt to a terminal level of 35% Debt to Equity. The default probability drops over time corresponding to the reduction in debt level. The ROE trends downward over time to a terminal level of 63.8% which reflects the reduction in leverage as well as the larger asset base. The larger asset base arises principally from purchased franchise rights. Margins remain relatively constant reflecting that we do not foresee aggressive competition arising.
Using the forecast above we used the eVal software to calculate per share values for Weight Watchers. We assumed a discount rate of 10%. We conducted a sensitivity analysis for a range of Cost of Equity values from 8%-14%. Additionally we recognize that since the company uses little in the way of Assets the crucial metric for its performance is its margins. Historically COGS/Sales have been gradually improving to their current level of 45%. We believe that margins will stay constant as increasing advertising expenditures to fend off potential entrants is balanced by operational scale efficiencies gained from consolidation of franchises. Using the COGS/Sales percentage as a control for margins we conducted a sensitivity analysis from 40%-50% COGS/Sales. Exhibit 5 below summarizes the results of this analysis. Our base case assumption is for constant margins and a 10% cost of Equity which translates to a $42.90 per share price.
Compared to a 12/02 closing price of $37.02 our estimate of a $42.90 per share price indicates that the stock is undervalued by 14% and represents an attractive buying opportunity. Important risk factors that could dramatically reduce our valuation include: erosion of sales driven by growing popularity of low carb diets, potential massive impairment charges against the Intangible Assets and credible competition from a new entrant.