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Our Take on Big Movers Valeant and Weight Watchers

Jason Stipp
Jeremy Glaser

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five, Morningstar's take on five stories in the market this week.

Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: A big news week in the market. Let's start with Weight Watchers. Oprah is now partnering with the firm. That gave the shares a big boost, but our analyst is not quite so optimistic.

Glaser: This week could easily have been The Friday 15 or The Friday 20, given the amount of news that came in.

One of the big stories was Oprah's 10% stake in Weight Watchers. She will be taking a seat on the board, and she's also going to help with the marketing. The stock doubled on this news, so it obviously was a big win.

We think that this is undeniably positive for the company; we doubled our fair value estimate, and increased a lot of our estimates of what Weight Watchers can do. But there are some things that investors do need to keep in mind. Weight Watchers is under a lot of pressure from free calorie-counting apps and from fitness trackers that have apps--different new competitive sources that are holding down their pricing power and making it difficult for them to pass along price increases and to recruit new members. That's a challenge for them that's not going to go away just because Oprah is onboard. And while Oprah will resonate probably quite a bit with Weight Watchers' core customer, it's not clear if she's going to bring in a lot of new, maybe younger members who would also help bring recruitment goals back.

There are some other positive things going on at the company. They have a business-to-business segment that partners with insurers and employers to try to help employees reach weight-loss goals. There is some good growth there. But given where the stock is trading right now, we just don't see a lot of value in it and think that investors would need a margin of safety and probably a pretty big one before considering the shares.

Stipp: Experiencing another dramatic move, but on the downside, was Valeant. There was some news this week from a short seller, a research firm. What is the story there? It has caused a lot of turbulence.

Glaser: This was an incredibly turbulent week for Valeant. The key flashpoint was a report that released on Wednesday alleging that Valeant basically set up these shell specialty pharmacies that allow it to essentially stuff the channel with drugs that they are not able to sell otherwise and recognize that revenue.

Management has categorically denied all of these claims, said that they are not founded, that revenue isn't being recognized in that way and only gets recognized when the drugs are actually in the hands of the consumers. The firm has come out very strongly against the claims, and that helped the shares come back a little bit. But they are still down substantially, and this has been a significant overhang this week.

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This news comes after pretty difficult couple of months for the company, as there are also concerns about drug pricing generally. There has been lot of attention paid to it by politicians and others. There is some thinking that there could be more pressure on keeping drug prices under control, which is something that would be challenging for Valeant's business model.

So what does this mean for investors? Shares are down substantially now, and we do think that on many measures they look pretty cheap. There are some positive things going on at Valeant. You look at things like their ophthalmology products. Those are probably insulated from these other issues and will continue to produce cash flow and support our narrow-moat rating on the company.

But there is a tremendous amount of uncertainty--not just your normal uncertainty with companies, where you just don't know what the future is going to bring and you want a margin of safety. There's a lot of event risk here now. We don't know exactly what's going to happen from all of these investigations. More information might come out in the weeks ahead, and we could expect more volatility there.

Michael Waterhouse, who covers this company for Morningstar, thinks that investors, if they do buy the shares, need an incredible tolerance for risk, and need to be aware that there is a lot of uncertainty here. Most investors would be wiser to look elsewhere.

Stipp: We've had a recommendation on several automakers for a while, and GM results this week show a big part of that thesis is beginning to play out.

Glaser: We have talked about GM a lot, and I wanted to bring it up again this week, because they did have, in the words of Dave Whiston our auto analyst, an outstanding quarter. It was driven by North America GM, which sold a lot of light trucks and crossovers, which helped bring up profitability. It looks like they are going to reach their profitability targets almost a full year early compared to their guidance, which is impressive and shows that GM is starting to get the scale they need in order to get better profitability. That's been a big part of the thesis and why we've thought these shares had been undervalued for quite some time.

It wasn't all good news, obviously. China remains a weak point. China has affected many different companies, and for GM we saw that again. China didn't weigh too badly on results, but definitely it was not a bright spot.

We still think the shares are undervalued, even after they traded up after these results. But we should point out this is a high-uncertainty firm; this is a no-moat company. But given the kind of undervaluation that's still there, it could be attractive.

Stipp: Online retailer Amazon surprised in the second quarter. They released results this week and surprised again. What's driving the great performance for them?

Glaser: Amazon is trying to shed the label that they are a business that will never be profitable, or that they will have to invest so heavily they'll never be able to see profitability. We saw it in the second quarter; we've seen it again in the third quarter.

To be clear, they are not making a ton of money right now. The profits they are turning are relatively modest. But results did show signs of how the company can have a path toward bigger profitability. R.J. Hottovy, Morningstar's Amazon analyst, sees that as one of the key drivers of the shares going forward.

In the quarter, Amazon web services performed really well. That business is coming into its own as a powerful driver of the business. Overall sales were up by almost a quarter year-over-year. They are still seeing very good growth. And yes they still are investing pretty heavily across a number of different parts of the business. But you're seeing signs that those investments are paying off. This isn't just cash that's being flushed down the toilet or on vanity projects. They are being careful about where they are investing, walking away from things like the phone where the investments weren't paying off, and I think that's good to see.

Stipp: There were some positive signs for fast-food giant McDonald's in their earnings report this week. Is the firm finally turning a corner?

Glaser: There are signs of progress. It's too early to say that they have hit an inflection point and it's all going to be looking up from here. But the quarter looked pretty good. For the first time in two years, they had positive same-store sales growth in United States--a 0.9% increase. That is very positive to see.

Our McDonald's analyst thinks two things were important from the quarter. The first was that the sales growth was not just led by one new hit product that people wanted to check out, but maybe isn't sustainable. It was really driven by a number of things: better quality ingredients across a number of different menu items, investments in labor, investments in training to make sure that order fulfillments are faster to keep customers coming back. Those were definitely a big part of it.

The second is how quickly they were able to roll out all-day breakfast. Those results we don't really see yet in this quarter--that's going to be more of fourth quarter and beyond phenomena. But the fact that they were able to go from limited tests to a nationwide rollout pretty quickly shows that some of the issues with their supply chain and execution that bedeviled the company for a while are behind them. This bodes well for management's ability to course-correct the things that do need to be changed. They'll be able to roll those changes out quickly. It wasn't clear that was possible before.

Despite all this good news, though, the shares don't really look attractive. The positive news is baked into the share price right now. We did raise our fair value estimate modestly after this quarter, but it doesn't look like there is a big margin of safety investors would need to dive in. But from an operations standpoint, it definitely was a positive quarter.

Stipp: Lots of headlines to sift through this week. Jeremy, thanks for helping us keep on top of it all.

Glaser: You're welcome Jason.

Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.