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Destroying Your Waistline Along With Shareholder Value

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When it comes to weight loss programs, most are gimmicky and show mixed results. They are popular for a while and then fade into irrelevance as the next fad becomes mainstream. Weight Watchers (NYSE: WTW), however, is different. They don't offer some "miracle pill" that guarantees results. They don't claim that you can magically see results without exercise. Weight Watchers offers a proven eat-less exercise more system that has worked for millions of customers. They have a recognizable brand name and an extensive network of weekly meetings attended by more than 1 million customers.

This ecosystem which Weight Watchers has built puts the company ahead of the competition. Herbalife (NYSE: HLF), which sells weight-management and nutrition products through a direct-sales network, was recently a victim of claims by hedge fund manager Bill Ackman that the company was a pyramid scheme bound to collapse. His enormous short position sent shares tumbling. Much smaller competitor NutriSystem (NASDAQ: NTRI) saw its share price collapse after revenue and earnings fell substantially in their earnings report issued in November. This comes after a steep revenue decline in 2011.

Weight Watchers looks like the best of the bunch. The company has had a consistent free cash flow of around $250 million per year for the last decade while revenue has grown by 125% since 2002.

But There's A Problem...

Weight Watchers has been extremely aggressive about buying back shares over the past decade, reducing the share count from 110 million in 2002 to 74 million by 2011, a decline of nearly 33%. I don't like to see companies overpay for their own shares, and it seems like Weight Watchers definitely paid a premium during this time.

But what has caused me to completely avoid Weight Watchers occurred in early 2012. In March Weight Watchers, through a tender offer, repurchased 8.78 million shares at a purchase price of $82 per share. In addition, the company repurchased another 9.499 million shares from its largest shareholder for $82 per share. The company took on an additional $1.5 billion of debt in order to accomplish this. The program reduced the share count from 74 million to 57 million, a 23% reduction. At the time the share price was hovering around $80 per share. (WTW 10-Q)

Why Was This A Bad Idea?

Data from Morningstar

Let's look at Weight Watchers financial position at the end of 2011, before this massive buyback. The balance sheet showed $1.05 billion in net debt, or $14.22 per share based on 74 million outstanding shares. Owner earnings were $360 million, or $4.87 per share.

I'll do a simple discounted cash flow calculation with a 12% discount rate to determine the fair value at the end of 2011. I'll assume that owner earnings grow at the average analyst estimate for earnings growth of 10.3% over the next five years (which is most likely wrong, as analysts tend to be), and at 3% perpetually after that. After subtracting the debt I arrive at about $60 per share.

We can disagree on the exact numbers used here, but one thing is clear: $82 per share certainly wasn't cheap. As Warren Buffett has said of share buybacks: "What is smart at one price is dumb at another".

So how does this decision to take on debt to overpay for its own shares affect the common shareholder? Well, after the buyback was completed Weight Watchers had reduced its share count to 57 million shares. Total debt now totaled $2.49 billion, or a whopping $43.75 per share. Although profitability has actually decreased so far in 2012, let's assume that owner earnings for 2012 match those of 2011, $360 million or $6.32 per share using the new share count. Using the same parameters from above the new fair value for a share of Weight Watchers is $53.44.

This is what happens when you overpay for your own shares - you hurt the common shareholder. The people who accepted the tender offer for $82 per share made out like bandits, as the current share price is around $60 per share. Those who stayed saw the real value as well as the market value of their shares fall. This reeks of a desperate attempt to boost the share price which in the end did exactly the opposite.

The Bottom Line

Although Weight Watchers' business model is top notch and the company is very consistent in its profitability, this was about the most absurd share buyback program I've seen. Loading up the company with debt to repurchase shares at an inflated price is a terrible idea, plain and simple. Avoid Weight Watchers.


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