On Weight Wathers

Weight Watchers certainly looks undervalued right now.  The Fool certainly agrees, but there isn't much substance behind their argument. 

Geoff Gannon recently put 25% of his investment portfolio into WTW.  Here is his analysis:

From there, my thinking was:

• Weight Watchers is the most psychologically powerful general weight loss program I know of
• WTW is basically a publicly traded LBO
• The stock is much more volatile than the business
• Investors treat marketing misses the way they treat fashion misses in apparel retail - so you should buy the stock when they mess up marketing
• WTW has a high free cash flow yield (low price to 10-year average earnings, etc.)
• Doesn't require net tangible assets to run the business - can pay out 100% of reported earnings (and then some)
• Stock dropped 20% right before I bought
• High short interest relative to float  (most trading is short-term and institutional)
• Stock price is the same it was 10 years ago. Company has doubled in size. Each share has doubled in percentage of ownership. There are now 4 times more sales per share than 10 years ago - but the price is the same. Most stock are more expensive than they were 10 years ago. This one is 75% cheaper.

Against this:

• They have a lot of debt.
• Business performance next year will definitely suck. It may suck for the next few years.

How I framed it:

• Write-off the next 3+ years
• Imagine what the stock should trade for in a "normal" January 2017.

Under normal circumstances, I saw no justification for a price below $52 a share. This is 15 times what I expect reported earnings would be in 2017 ($3.50 a share ). Free cash flow would be higher than EPS. That's a 10% return over 3 years. I could live with that.

Do I think they will produce zero free cash flow for 3 years?

No.

Do I think they will buy back zero shares for 3 years?

No.

Do I think it will take a full 3 years for sentiment to turn?

No.

Therefore, I felt the upside was somewhere between 10% a year and a lot. The cost of getting a chance at the “a lot” is 3 years of volatile discomfort.

In my experience, it rarely takes 3 years. But I always tell myself it will.

What could derail this?

The debt:

• If WTW issues shares, I will lose money. 
• If WTW uses all free cash flow to pay down debt, I won't beat the market. 

Both are possible when you owe more than 4 years of EBITDA – and you expect EBITDA to decline – as WTW does.

The debt is a big risk. If the market cap was the same and there was no debt, I would have bought this stock a long time ago.

We are not talking about a low EV/EBITDA stock here. WTW is not a value stock.