Weight Watchers' Attractive Figures


By Howard Choe Rising rates of obesity among the general population -- and the health problems they may engender -- have grabbed the spotlight in recent months. So it may seem surprising that shares of Weight Watchers International (WTW

; recent price, $40), the world's leading provider of weight-loss services, haven't bulked up in the past 12 months as much as the overall stock market. (The stock posted a gain of 8.1%, vs. the S&P 500's rise of 11.8%.)

But we at Standard & Poor's Equity Research Services believe this is an opportune time to purchase Weight Watchers, based on what we view as an attractive valuation and the outfit's long-term prospects. With the growing problem of obesity in developed countries, especially in North America, we believe it is well positioned to benefit as individuals and institutions attempt to tackle this issue.

STAYING POWER. We also believe Weight Watchers has an attractive business model, which drives high profit margins and strong cash flow. Given its leadership position, we believe it is well situated to benefit from the growing trend of obesity in developed countries and to weather the storm of what we regard as short-lived fad diets.

We expect that improvement in North American attendance will be the main catalyst for the stock over the next 12 months. We think comparisons of results in upcoming periods vs. the prior year should be favorable.

And with the shares attractively valued, in our view, we believe Weight Watchers will significantly outperform the S&P 500 over the next 12 months. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

HEFTY CROWDS. Weight Watchers operates in 30 countries. It's programs aim to help people lose weight and then maintain those losses. At the core of Weight Watchers' business are weekly meetings, which promote weight loss through education and group support in conjunction with a flexible, healthy diet. Each week, over 1.5 million people attend approximately 46,000 Weight Watchers meetings around the world, which are run by over 15,800 classroom leaders.

Weight Watchers maintains high margins and generates strong cash flow due to its low variable expenses and low capital expenditure requirements. Revenues are primarily generated from the collection of meeting fees (64% of the 2003 total) and product sales (29%). The costs involved in running a meeting are low, with part-time class instructors being paid on commission, and many meeting locations rented on an hourly basis.

The company's businesses are highly profitable, with gross and operating margins averaging over 53% and 34%, respectively, over the past three years. Meeting fees are paid upfront or at the time of the meeting by attendees, which results in net negative working capital for Weight Watchers -- an indication of cash-flow efficiency.

CORE VALUE. Capital expenditures are extremely low, less than 1% of sales. In 2003, Weight Watchers generated more free cash flow (defined as cash flow from operations less capital expenditures) than net income ($214 million versus $174 million). When comparing free cash flow as a percentage of sales to the S&P 500 in the past fiscal year, Weight Watchers' 24.2% far exceeded the 5.8% average generated by the S&P 500.

We expect North American results to improve in future periods, owing to a new, easy-to-use program and our belief in the waning popularity of low-carb diets. In our view, results in North America have been weak over the past year due to the popularity of the Atkins and similar diets, and, to a lesser extent, the availability of low-carb packaged foods.

But to the average person, however, we think this has been a confusing time with mixed messages and many options available to them. In times of confusion, we believe the category leader (in this case, Weight Watchers) will eventually benefit, as consumers are drawn to leading, proven brands. Indeed, we believe this trend became evident in the last quarter for the company as the rate of North American attendance declines slowed. In order to offer the ease of use that the low-carb diets provide, the outfit introduced a new program in August named the Core Plan, which eliminates the need to count points and does not restrict portion sizes.

MARGINS DOWN, MARGINS UP. In addition to the new program, we believe there are several other drivers for the company over the next 12 months such as continued growth in international markets and licensing opportunities. Weight Watchers stock should also get support from the company's active share repurchase program.

We expect sales to climb approximately 4% in 2004, reflecting healthy international attendance growth, but declining attendance in Weight Watchers' North American operations. We expect sales to rise 7% in 2005, due to the new Core Plan program and products.

We see margin deterioration in 2004, largely due to higher marketing expenses associated with sales territories acquired from franchisees and higher legal, insurance, regulatory, and compliance costs. We expect margins to expand in 2005 due to improved leverage on higher sales. Interest expense should decline, and we project modest share repurchases.

We see earnings per share for 2004 advancing to $1.66, from $1.59 (excluding unusual items) in 2003. For 2005, we estimate EPS of $1.86.

We believe the quality of Weight Watchers' earnings is high relative to its peers. After a adjustments made to its GAAP-based net income from continuing operations, and before extraordinary items to conform to S&P Core Earnings methodology, 2003 net income per share of $1.59 would be reduced to $1.57, a differential of less than 2%. This compares favorably to the average 17% negative variance for the personal-care companies we follow.

SIGNIFICANT DISCOUNT. For 2004, we project S&P Core Earnings of $1.64, also a less than 2% reduction from our operating EPS estimate of $1.66. The reduction for option-expense accounts for all of the difference between the two estimates, as Weight Watchers does not have a pension plan. We project 2005 S&P Core EPS of $1.83, again reflecting projected stock-option expense.

Given our view of the potential for Weight Watchers to generate a high level of cash flow and operating margins, we believe the shares should trade at a premium to the S&P 500. Weight Watchers recently traded at a p-e-to-growth ratio of 1.6, about in line with the S&P 500. Its recent forward p-e of 21 is at a significant discount to its three-year average of 24. Our 12-month target price is $48, or 22 times our 2006 EPS estimate of $2.18.

Our

discounted cash-flow (DCF) model calculates an intrinsic value of about $48. Based on our DCF value and our target p-e of 22 for estimated 2006 EPS, we arrive at a 12-month target price of $48, approximately 20% above recent price levels.

Risks to our recommendation and target price, in our view, include higher consumer acceptance of do-it-yourself diet programs, low acceptance of new Weight Watchers programs, and a slow recovery of the company's domestic operations. Choe is an analyst following consumer discretionary stocks for Standard & Poor's Equity Research Services


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