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Morningstar | Business Model Adjustments Will Weigh on Weight Watchers Near Term but Brand Transformation on Track

Weight Watchers' third quarter marked a bump in the road for its longer-term brand transformation, with the market honing in more on the negatives (a deceleration in studio/in-person meeting revenue growth to 2% from 10% last quarter, fall marketing that didn't match its summer campaign, and U.K. competition) than the positives (the success of Invite a Friend, positive retention readthroughs from the new loyalty program, and new partnerships to help relevancy). Additionally, with initiatives impacting financials in ways that haven't been seen historically--the invited friend and referring member each receive a free month of membership under Invite a Friend, for example--the market is still adjusting to Weight Watchers' evolving investment thesis. While the Invite a Friend program will likely weigh on results heading into 2019--and reinforces the industry competition that makes up our no-moat rating--management still deserves credit for improving the relevancy of the brand and connecting with non-traditional members, seeking out unique/asset-light partnerships and sales channels (including third-party locations for studio/meeting square footage and a new meal kit partnership with Blue Apron), increasing member retention, and building a more holistic and dynamic business model.

We're not planning material changes to our $65 fair value estimate, as adjustments for full-year guidance (including a reduction in full-year revenue to $1.53 billion from $1.55 billion and 400 basis points of gross margin expansion versus 425) were largely the result of temporary pressures such as Invite a Friend, inventory clearance ahead the launch of a line of new consumer products, and softer U.K. results that reverse in future periods, we see today's pullback as an overreaction. While we'd prefer a wider margin of safety, we identify several near-term (holiday marketing and new ambassadors) and longer-term catalysts that should help the company toward its 2020 goals.

Like last quarter, we believe one of the most important developments is reaching non-traditional members. Keeping pace with the first half of the year, 40% of third-quarter member signups were new to Weight Watchers, with the aforementioned Invite a Friend program helping to attract members outside of Weight Watchers' traditional over-50 female demographic (men, for instance, made up 17% of the Invite a Friend sign-ups). While the fall marketing campaign didn't have the same impact as its summer efforts--something management attributed to less global coordination, though management intends to use more consistent global messaging in its important winter campaign--Weight Watchers' marketing efficiency remains strong with reported subscriber value to cost per member ratio still above five times. Member duration also remains close to peak levels--nearing 10 months--reinforcing new platform engagement measures. We expect this trend to continue to grow near term with expanded health and wellness, loyalty program, Blue Apron, in-app sales (both products and services), new e-commerce product initiatives, and partnerships/acquisitions yet to be announced.

Our updated model assumes 2018 revenue of around $1.53 billion, 17% growth, including 16% reported growth in North America, 8% reported growth in the U.K., and mid- to high-20s reported growth in Continental Europe. We believe gross margins guidance calling for 400 basis points of leverage (implying full-year gross margins around 57%) appropriately balances the improved operating leverage in the platform with other technology and engagement investments, while expected marketing and G&A costs of $235 million and $245 million should put the company comfortably within its new full-year EPS target range calling for $3.15-$3.25 (which also assumes an 11% tax rate for the year).

Looking longer-term, we're sticking with our 2020 revenue outlook of $1.9 billion--versus management's goal of $2.0 billion--as the third-quarter softness will be offset by more optimistic online paid week projections over the next two years. We are maintaining our 2020 gross margin outlook of 60% and adjusted operating margins outlook of approximately 30%, which gives the company credit for the incremental leverage inherent in the model through the margin-accretive nature of new partnership structures and the shift to the online channel. We continue to see a great deal of innovation in management's plans to become a more comprehensive health and wellness provider and see management's target of 5 million active subscribers and another 5 million individuals "engaged in other ways" including sponsored cruises, new content (including some content derived from a new pilot program with meditation platform Headspace), or social media with other technology-based health and wellness solutions as an attainable longer-term goal.