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Morningstar | Subpar Marketing, Substitutes a Concern but Weight Watchers Still Has Growth Potential; Under Review

After Weight Watchers' disappointing fourth-quarter update and 2019 outlook, the key question for investors is whether near-term weakness reflects self-inflicted (WW brand transition and winter marketing campaign issues) and competitive substitutes (keto) or if there are more structural issues at play.

We did underestimate the impact of new substitutes but ultimately find ourselves in the former camp. While 2019 is now a show-me story, we believe there are several reasons WW is better positioned to bounce back versus other difficult periods in its history: (1) Average duration still remains well over historical averages of nine months, suggesting efforts to make the brand a more holistic solution are gaining traction with new members and can help nullify some of the impact of substitutes. (2) New recruitment strategies like Invite a Friend are improving brand relevancy among nontraditional members. (3) We believe asset-light partnerships and sales channels (including third-party locations for studio/meetings and direct-to-consumer solutions) are margin-accretive ways to build the brand. (4) Efforts to optimize and modernize the in-person meeting experience should become more apparent as the year progresses.

While we have questions about the impact that substitutes could have on near-term pricing--also a factor in our no-moat rating--we believe the sell-off is overdone. Management's 2019 outlook--revenue of $1.4 billion (down 8% from 2018), implied operating margins in the high teens (versus 25.7%), and EPS of $1.25-$1.50 (versus $3.19)--is tough to swallow, but we believe the current share price assumes no long-term revenue growth and margin expansion. We still see a path to low-single-digit growth and operating margins in the mid-20s, which balances positive company initiatives with evolving industry trends. We're placing the shares under review and plan a 30% decrease to our $65 fair value estimate but still see an opportunity for longer-term investors.

Based on trends heading into the new year, management's initial 2019 guidance strikes us as reasonable. In addition to a revenue decline of roughly 8%, management also expects 300 basis points of gross margin pressure (implying full-year gross margins around 54%) due to operating deleverage in the platform and $250 million apiece for marketing and general and administrative expenses (representing a year-over-year step-up in marketing to reignite member recruitment and essentially flat G&A due to ongoing technology and other digital investments). However, we're intrigued by management's plan to identify greater cost-saving opportunities--which we expect to come primarily through the cost of services/product sales or SG&A line items--and could offer upside surprises to management's GAAP EPS forecast of $1.25-$1.50 (which also assumes a 25% tax rate for the year and 70 million shares outstanding).

Looking longer term, management noted that it will take more time to reach $2 billion in revenue than its previously communicated goal of 2020. We had always assumed that this target would probably be aggressive--our previous outlook called for $1.9 billion in 2020--but now see this as a reasonable goal for the later years of our 10-year explicit discounted cash flow forecast horizon. Assuming the company can return to low- to mid-single-digit growth, we believe gross margins can return to the high 50s and adjusted operating margins to the mid-20s over this forecast period, especially after factoring in the margin-accretive nature of new partnership structures and the shift to the online channel.