Avoid This Debt-Laden Company

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

The weight-loss industry is big. In the United States alone weight-loss companies record about $20 billion in annual revenue, and at any given time over 100 million Americans are attempting to diet. Weight loss systems come and go, with many proving to be ineffective at best and dangerous at worst. But Weight Watchers (NYSE: WTW) has been around for decades, watching fads come and go as it has grown into one of the largest weight-loss companies in the world.

What makes Weight Watchers special

The Weight Watchers program is based on a point system. Everything you eat and drink throughout the day is assigned a point value based on a set of formulas, and the goal is to not exceed the maximum number of points. The method works by making sure that you burn more calories than you take in, creating a calorie deficit which leads to weight loss. The point system simplifies this process and makes it easier keep track of what you eat.

The big thing that differentiates Weight Watchers from the competition is its vast network of meetings. Over 40,000 meetings are held each week. The company collects a weekly fee for attending these meetings, which provide support and motivation to members. This infrastructure, along with a well recognized brand, gives Weight Watchers a distinct long-term advantage in its industry.

Bad decisions

In January I wrote an article entitled Destroying Your Waistline Along With Shareholder Value which criticized the company for a destructive share buyback program. In early 2012 Weight Watchers took on a massive amount of debt to purchase shares for $82 each through a tender offer as well as from its largest shareholder. This action reduced the share count by about 24% while adding significantly to the debt.

Since that time the share price has plummeted to around $45 per share, down 45% from the price paid for the buybacks.

<img alt="" src="http://media.ycharts.com/charts/340f628d79b3ece2ef7f053c3acdd808.png" />

WTW data by YCharts

I argued that Weight Watchers was not worth anywhere close to $82 per share and that the company was vastly overpaying for its own shares. This led to a destruction of shareholder value and large interest payments eating up profits. The market apparently came to the same conclusion.

But now that the stock has fallen by so much it's time to take another look at Weight Watchers. Does the stock offer value at the current depressed price?

So much debt

As of the end of the first quarter Weight Watchers has a total debt of $2.4 billion. This is just about the same as the market cap of the company and on a per-share basis comes out to an astonishing $42.85 per share. The company does have about $120 million in cash, but it appears that this cash is part of the working capital and thus probably shouldn't be considered excess cash.

In the past 12 months Weight Watchers has spent $100 million on interest payments on this massive debt, about 20% of its operating income. The company recently refinanced much of its debt, leading to an increase of about $18 million in the annual interest expense. It looks like the company will be paying about $120 million on its debt in the future.

Highly profitable

Weight Watchers generates exceptional profits. In 2012 operating margin sat at 28%, with a net income margin of 14% and a free cash flow margin of 14.8%. I prefer to look at owner earnings instead of either net income or free cash flow because I believe it better represents the true profitability of the company. Owner earnings are similar to free cash flow except for the exclusion of certain items such as changes in working capital and the addition of tax-adjusted interest payments. In 2012 Weight Watchers had owner earnings of about $295 million, or $5.27 per share. This is down a bit from 2011 due to both an increase in interest expense and a decrease in operating profits.

With a share price of about $45 it would appear that the stock is cheap. But the debt needs to be taken into account, and after adding the net debt to the share price the adjusted price-per-owner-earnings ratio sits at about 16.7. This is a lot higher than the traditional P/E ratio of 10.6. Ignoring the debt could lead one to believe that Weight Watchers is a bargain, but it's really not.

How much is Weight Watchers worth? I'll do a simple discounted cash flow calculation to find out. Analysts are predicting anemic earnings growth for the next five years, and with 2012 seeing a decline and the interest expense set to rise I tend to agree. I'll consider three different growth scenarios, and I'll use a discount rate of both 12% and 15% to define a fair value range.

  1. Anemic growth - owner earnings grow by 3% annually in perpetuity.
  2. Slow growth - owner earnings grow by 6% annually for the next 10 years and by 3% annually after that.
  3. Fast growth - owner earnings grow by 9% annually for the next 10 years and by 3% annually after that.

Here are the fair value ranges for all three growth scenarios:

<table> <thead> <tr><th><strong>Scenario</strong></th><th><strong>Low-end</strong></th><th><strong>High-end</strong></th></tr> </thead> <tbody> <tr> <td><strong>Anemic</strong></td> <td>$0</td> <td>$17.46</td> </tr> <tr> <td><strong>Slow</strong></td> <td>$11.77</td> <td>$31.35</td> </tr> <tr> <td><strong>Fast</strong></td> <td>$23.33</td> <td>$48.65</td> </tr> </tbody> </table>

In my previous article on Weight Watchers I set the growth rate to the average analyst estimate at the time, which was 10.3%. I stated that this number was most likely an overestimate, and now analysts have lowered that rate dramatically. Because of the massive amount of debt if Weight Watchers can't manage any real growth going forward the stock is worth next to nothing. The Fast scenario is closest to the original article, and under this scenario the stock is fairly valued. So Weight Watchers needs to basically match its growth rates from the past to be fairly valued today. I don't think this is likely to happen.

Are there any better options?

Weight Watchers is the best weight-loss company but not the best stock. No competitor matches Weight Watchers' meeting infrastructure and advantages. Nutrisystem (NASDAQ: NTRI) is a much smaller company with no debt, but the company isn't all that attractive otherwise. Revenue has been declining since 2007, margins have fallen off a cliff, and 2012 saw net income turn negative. The first quarter of 2013 doesn't look much better. The company does pay a nearly 6% dividend, but I suspect that this may be cut sometime soon.

Another alternative company is Herbalife (NYSE: HLF). The company has some debt, about $250 million after accounting for the cash, but this pales in comparison to Weight Watchers. The stock trades at a debt-adjusted 14 times owner earnings, quite a bit lower than Weight Watchers, and also offers a higher dividend yield. Revenue has been growing fast, with 2012 seeing an 18% increase, and it would appear that the stock is cheap based on its growth prospects. There is significant controversy surrounding the company, however, with hedge fund manager Bill Ackman shorting the stock and claiming that Herbalife is a pyramid scheme. So it may be best to stay away.

The bottom line

Weight Watchers is a good company weighed down by its massive debt. The company needs to see fast growth in order to justify its share price, but I think that growth going forward will be slow at best. Although I've seen plenty of articles recently claiming that Weight Watchers is cheap, the debt levels greatly skew traditional metrics. At $30 per share Weight Watchers would be worth another look, but the price right now is far too optimistic.

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Timothy Green has no position in any stocks mentioned. The Motley Fool has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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