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Friday, December 11, 2009

Watching the World's Weight with Weight Watchers (WTW)

NutriSystem (NTRI, $29.45) has had an amazing run over past several months on news of expanded distribution with major retailers, which should lead to accelerated growth. Here is the three month stock chart:

We looked at the company in the mid-teens last summer but didn't purchase shares. Although we like the business, we didn't expect shares to move so sharply in the near-term and wanted to keep following the company. It appears the stock responded in similar fashion to the overall market this year, albeit even more quickly -- some good news yields a sentiment shift and concurrent short squeeze that leads to a meaningful upward move. Here's short interest data from Nasdaq.com:

While we missed NTRI (*momentum may yet push shares higher, but we're not in that game), we did recently initiate a small position in Weight Watchers (WTW, $27.81). We see a favorable risk/reward profile given a high quality business model and free cash flow generation. At a 10% TTM FCF yield, we wouldn't mind buying the entire company, and, further debt reduction should enable a higher dividend in two to three years. This, along with slight earnings growth, makes at least slight multiple expansion plausible over the medium term.

Here's a summary thesis with more detail from an analysis we completed in early November (valuation data updated for NTRI and WTW comparison):

Consistently high margins/ROIC and excess cash flow indicate that Weight Watchers operates a high quality business model with durable franchise characteristics. On balance, strengths and opportunities appear to outweigh key weaknesses/threats such as growth concerns, competition, and debt levels. Importantly, a baseline forecast that assumes stable Y/Y revenue in fiscal 2010 (easier Y/Y comparisons and stable economy) followed by slight growth in fiscal 2011 implies that net debt to EBITDA will decline to 2.2x at year-end 2011 from an estimated 3.3x at year-end 2009 (and 3.6x at year-end 2008), providing more than adequate cushion for lenders and the current dividend. At that point, Weight Watchers may finally be able to initiate annual dividend increases, which could lead to higher valuation multiples.
  • The baseline forecast produces a valuation range between $17 (earnings power value) and $40 (private market value)
  • Applying historical 5-year median P/E, P/FCFE, and TMV/EBITDA multiples to forward estimates implies approximately 100% upside at year-end F2009/F2010
  • Even haircuts to historic multiples imply substantial upside
  • On a comparable basis, as of 12/11/09, NutriSystem was trading at 38x TTM earnings and 21x consensus 2010 earnings (5% earnings yield), compared to Weight Watchers at 10x both TTM and consensus 2010 earnings (10% earnings yield)
Conclusion: while growth remains a critical question and multiple expansion is not guaranteed in the current environment, the prospect of a high quality business model once again garnering discounted historic multiples (at minimum) seems a high probability event with a three-year investment horizon. Investors collect 2.6% per year while waiting and potentially more in several years. Assuming normalized earnings growth in the mid-single digits (4-6%), investors should collect a total return of 7-9% over time assuming no multiple expansion.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long WTW.

© 2009 Jeffrey Walkenhorst
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