WTW: Initiating Short

Takeaway: This could be WTW’s worst winter selling season in the last 7 years. Issues could be secular.

THESIS SUMMARY

  1. 2014 Consensus Estimates are a Stretch: Our Google Trackers suggest that membership trends are deteriorating sharply on a y/y basis in 1Q14, which is concerning since the first quarter sets the tone for the year.  If 1Q14 is off to a weak start, WTW isn't likely to recover from it.
  2. Heads They Lose, Tails They Lose: WTW has considerably scaled back its marketing expenses, which is what we believe explains the muted 1Q14 demand trends.  We suspect the company’s hands were tied since it is dangerously close to breaching certain escalators in its Credit Agreement.  WTW needs to invest to get out of its hole, but lacks the ability to do without triggering its escalators.
  3. Is this Secular?  WTW remains a recognized leader in the weight-loss industry, but is facing heightened competition from free apps and online services.  We suspect it will tougher for WTW to to gain/preserve membership moving forward.   WTW’s B2B opportunity seems more like wishful thinking than a viable growth objective in post-Obamacare world.  The end-user is facing pressured profits, and is more likely to scale back, than add on.  
  4. $23 Stock?: We were early to cover, but now believe it can go lower than we originally expected.  We estimate that the stock could trade as low as $22-$23 based on our updated EPS and EBITDA estimates  While short interest has crept up in the name, our proprietary SFP analysis suggests the shorts usually get this one right.

2014 CONSENSUS ESTIMATES ARE A STRETCH

We recently covered our short in WTW following its 3Q13 earnings release; after both 2014 consensus estimates collapsed and our WTW Google Tracker improved in 4Q13.  The latter suggested that 2013 ending membership (i.e. 2014 starting membership) may be better than the recent trend suggested.  However, we were too quick to cover. 

Our WTW Google Trackers have inflected, and are showing a sharp deceleration into the critical 1Q14 selling season, which is concerning since WTW membership seasonally declines every quarter after the first.  So if 1Q14 is off to a weak start, WTW isn't likely to recover from it.

WTW: Initiating Short - WTW   Tracker vs. Attendence 1Q14

WTW: Initiating Short - WTW   2014 EPS Scenario Analysis   1 21 14 

 

HEADS THEY LOSE, TAILS THEY LOSE

WTW has been cutting back on expenses; most notably its dividend (suspended) and marketing expenditures; the latter of which we believe is driving the muted 1Q14 demand we highlighted above.

We suspect the company’s cost cutting initiative may be driven by the terms of its new Credit Agreement.  WTW has certain escalators in Credit agreement, which will increase the “applicable rate” in its term loans based on the company’s consolidated leverage ratio (schedule below).

WTW: Initiating Short - WTW   Credit Agreement Esclators

Additionally, there in another escalator based on its credit ratings; WTW already breached the S&P rating, and if Moody’s downgrades the company, which seems likely given its outlook (here), the escalator would be triggered. 

Collectively, we expect annual incremental interest from these escalators could  be as high as ~$12mm, or $0.14 hit to 2014 EPS (depending on when they are triggered). 

More importantly, we believe WTW needs to invest (particularly in Marketing) to get out of its hole, but lacks the freedom to so without triggering its escalators.  However, by choosing to manage to cost structure instead of driving the top-line, the company’s EBITDA is at risk, and it will likely trigger its escalators regardless.

 


IS THIS SECULAR?

WTW remains a recognized leader in the weight-loss industry with a clinically-proven program, but is facing heighted competition from free apps and online services.  We suspect the company will have to work much harder to gain/preserve membership moving forward, which can mean anything from a redesigned product /price concessions to heightened marketing expenses/member acquisition costs.  What’s clear is that WTW’s current business model isn’t suited to drive/sustain membership in this evolving operating environment.  

WTW: Initiating Short - WTW   Marketing Campaign HRM est 1Q14

WTW’s B2B opportunity seems more like wishful thinking than a viable growth objective in post-Obamacare world.  The end-user (MCOs and Employers) is facing series of new regulations that will pressure profitability starting in 2014, and these pressures will only escalate in 2015 as the Managed Care Industry Tax increases and employer mandate to provide health insurance resumes.  We believe that both MCOs and employers collectively are more likely to scale back on incremental healthcare expenses, than tack on new ones. 

$23 STOCK? 

We were early to cover, but now believe it can go lower than we originally expected.  We estimate that 2014 earnings will be in the $2.45-$2.65 range. Assuming multiples compress 1x, we believe the could trade as low as $23 at the midpoint of our range.  Our EBITDA estimate of $377-$390 implies a $22 stock at its current EV/EBITDA multiple at the midpoint of our range.  While short interest has crept up in the name, our proprietary SFP analysis suggests the shorts usually get this one right.

Let us know if you have any questions, or would like to discuss further.

Hesham Shaaban, CFA

@HedgeyeHC2

 

Thomas W. Tobin

@HedgeyeHC