Oprah Lifts Weight Watchers

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However, with the stock price soaring since the partnership announcement, we believe Weight Watchers has moved into overbought territory, and we would exercise caution for several reasons. First, despite improving recruitment trends in the most recent quarter, we forecast a transitional year in 2016, including a low-to mid-single-digit revenue decline amid the lingering effect of recruitment difficulties in early 2015. In addition, we forecast operating margins declining to 14%-15% as a result of expense deleveraging (but partly mitigated by a $100 million cost-reduction plan), which may not be reflected in the market price. Second, many of the factors that hurt Weight Watchers during the past several years--including calorie-counting mobile apps and activity monitors--remain in place. We still believe these disruptive technologies have diminished the brand's pricing power, which ultimately led to the removal of our narrow moat rating. Finally, while Oprah's involvement is likely to resonate with Weight Watchers' traditional over-50 female demographic, it's unclear how the company plans to better position its brand for a younger audience.

Slow to Adapt to Changing Market Weight Watchers finds itself at a critical juncture. Competition from calorie-counting mobile apps and activity monitors has been an issue for several years, and initially, it appeared as if these headwinds were similar to previous periods when diet fads disrupted paid week trends. However, the severity of recent recruitment struggles implies more fundamental issues at hand, namely a platform lacking innovation, technology, and personalization. In CEO Jim Chambers' own words, Weight Watchers' offerings "have become less appealing in this changing market" and the company "missed out on the mobility revolution," which has led to new sources of competition and structural changes in the industry.

More specifically, we believe mobile apps and other technologies have commodified aspects of weight management. Although we don't view Weight Watchers' clinically proven weight-management platform as a commodity product--especially in an industry rife with false claims--we believe the lack of program and technology innovations has made it difficult for consumers to distinguish Weight Watchers' in-person and online businesses from new entrants, diminishing the brand's pricing power in the process.

Even with the announcement that Winfrey will join the board of directors and take a 10% stake in the company--a partnership that could offer some intriguing marketing synergies--we believe a turnaround will take time. Although we don't forecast positive revenue growth until at least 2017, we believe management is taking steps to differentiate its platform and improve its brand positioning, including creating personalized and on-demand consumer offerings by integrating in-person, online, and mobile platforms, including open API collaborations with leading fitness monitors. We also see an opportunity for Weight Watchers Health Solutions to grow in the $1.2 billion-$2.0 billion business-to-business weight-management category. Nevertheless, even with these initiatives, our overarching concern remains the pricing power of the Weight Watchers brand, as we believe efforts to drive recruitment via sampling or other promotional activity will put pressure on longer-term pricing.

Intense Competition Impairs Pricing Power We removed our narrow moat rating for Weight Watchers in March, as trends to date in 2015 indicate that the company's marketing, product, and technology enhancements are struggling to keep pace with evolving consumer perceptions about weight loss. Recruitment trends have improved modestly--online recruitments in North America were positive in the second quarter of 2015 for the first time since the fourth quarter of 2012, though total global recruitments remain down year over year--and we believe the company deserves credit for creating a more effective call to action than other promotions in the past several years with its "Lose 10 Pounds on Us" marketing approach. We also find Weight Watchers' partnership with Oprah Winfrey intriguing on a number of fronts, as it brings an unprecedented level of credibility and commitment to a Weight Watchers endorsement (evidenced by her appointment to the board of directors and 10% ownership stake via newly issued shares, with options to acquire an additional 5%) and potentially opens up new marketing synergies through Winfrey's various television, print, and digital properties. However, we cannot shake overarching concerns about the pricing power inherent in the Weight Watchers brand, as management continues to highlight ways to lower consumer barriers to its offerings, which we expect to include sampling or other promotional activity and put downward pressure on pricing over a longer horizon.

At first, we equated recent competition from calorie-counting mobile apps and activity monitors with other periods in Weight Watchers' history when diet fads disrupted attendance and paid week trends (including in 2004, when the popularity of the Atkins diet negatively affected results). Weight Watchers had historically bounced back from these diet trends, which we thought was representative of a strong brand intangible asset and provided the foundation for our previous narrow moat rating. However, we believe the severity of paid week and attendance declines (both in person and online) that plagued results in 2013-14 and are expected to continue throughout 2015 and into 2016 indicates that the success of calorie-counting mobile apps and activity monitors has been masking more fundamental issues in the business--namely, a lack of innovation, technology, and personalization. In our view, this invited new sources of competition and led to structural changes in the commercial weight-management industry.

Weight Watchers' brand recognition, comprehensive weight-management platform, meeting infrastructure, and product-licensing capabilities represent an intangible asset that is difficult to replicate. However, it is unclear whether the company's core weight-management program can restore its pricing power to previous levels, especially as mobile apps and other technologies have commodified aspects of the weight-management category. Although we don't necessarily view Weight Watchers' clinically proven weight-management platform as a commodity product--especially in an industry that is rife with false claims--a lack of innovation, technology, and personalization investments in the core in-person meetings (which represent more than 60% of total revenue, between the meeting fees and in-meeting product sales) and online platforms (30% of revenue) have made it more difficult for consumers to differentiate Weight Watchers from emergent rivals like calorie-counting apps and fitness monitors; they also make it more challenging for the company to target an audience beyond its traditional over-50 female demographic.

We appreciate management's comments on making the Weight Watchers brand a more relevant part of consumers' holistic approach to weight management, which also encapsulates healthier eating, fitness, and technology, and we're encouraged that upcoming marketing will accentuate areas complementary to weight management. Nevertheless, it remains unclear how the company plans to develop more comprehensive health and wellness solutions, though it probably involves a combination of its recent technology investments and creative partnerships with fitness and other wellness providers.

B2B May Be the Answer In our view, the Weight Watchers Health Solutions business may possesses the most defensible competitive attributes of the company's product portfolio, given its diverse and comprehensive service offerings and the specialized requirements of its insurer and employer target audience. We remain constructive about the company's opportunity to expand in the $1.2 billion-$2.0 billion business-to-business obesity and weight-management category. As noted at its November 2013 analyst day, Weight Watchers' workplace obesity program ranks high among employers and health plans because of the clinically proven results, a counseling-based approach (versus food- or drug-based programs), convenience for employees, the variety of tools/approaches to encourage regular engagement, and affordability.

However, Weight Watchers' B2B category growth has not kept pace with demand because of patient/employee data capture and management, privacy, eligibility, and billing deficiencies as well as a lack of sales/account management and customer service resources. Management made these capabilities a top priority in 2014--namely the introduction of a new tablet-based system that enables data sharing within workplace meeting environments--which has helped to better target employer and insurer partners, including the partnership with Humana announced in December 2014. That said, with the CEO's recent admission that 2016 is likely to be "another learning year" for Weight Watchers' healthcare business, this segment's long-term cash flow contribution becomes less visible. We still believe growth from this business unit can accelerate in 2017, assuming a continued rollout of data capture/sharing capabilities and expanded customer-service capabilities, though we believe the success of this unit is partially tied to the evolution of the core business, including recent tech upgrades and other platform innovations.

Uncertainty Requires Wide Margin of Safety Weight Watchers' recent recruitment struggles, which have led to a precipitous drop in paid weeks and total company revenue, have raised concerns about brand impairment or, at the very least, diminished pricing power. The resulting expense deleverage reinforces the intensity of current competitive pressures as well as the need to develop more substantive calls to action across its marketing and other consumer engagement efforts.

Our fair value estimate assumptions balance several near-term unknowns, such as limited visibility over near-term recruitment strategies and recent struggles positioning the Weight Watchers online program at a time when free calorie-counting mobile apps and activity monitors are increasing in popularity. We still identify longer-term opportunities in the fragmented $65 billion weight-management market, as the company still possesses a recognizable brand (bolstered by Winfrey's recent 10% stake in the company), a scientifically proven program to address obesity trends, and growth potential in the B2B healthcare market. However, we believe investors must approach Weight Watchers with a wide margin of safety based on uncertainty about near-term enrollments, a lack of visibility surrounding the company's B2B/healthcare pipeline, and execution risks tied to longer-term transformative plans.

Weight Watchers also faces potential risks from medical weight-management breakthroughs. If drugs or methods that are more effective than traditional nutrition and exercise are created, we think Weight Watchers would lose significant business. In addition, Weight Watchers' business is sensitive to consumer discretionary income. In an economic downturn, the company would face demand headwinds that could be magnified by its significant operating leverage.