There is a reason why debt matters. There is a reason why you have to dig in and study balance sheets instead of making investment decisions based on what you see pop up in a stock screener. For instance, imagine if you looked up Weight Watchers. You would see a stock generating $1.26 per share in profits and trading at a valuation of 5x earnings. That would look like a really good deal. You can reasonably think, “Hey, America has an obesity problem that is only going to get worse, and people are going to want to use services like Weight Watchers to get their BMI under control.”
This would likely lead to disaster because Weight Watchers has completely reckless management that tackled on an ungodly amount of debt during the early 2000s to repurchase stock and temporarily please Wall Street by beating expectations without giving a hoot about the long-term health of the business.
Between 2005 and 2015, Weight Watchers repurchased almost half of its stock. It reduced the share count from 100 million to 55 million. This covered up the inability of the business to execute operationally (profits declined from $202 million to $98 million over the past ten years). But the actual earnings per share growth appeared to be constant, as the share buyback only resulted in a decline of earnings per share from $1.50 to $1.20.
The problem with Weight Watchers is the structure of its debt. The company owes $300 million in April 2016, and had to borrow heavily to put itself in a position to make that debt payment. Weight Watchers has $301 million in cash on its balance sheet right now, and will be solvent through next April. The real problem comes in 2020. Weight Watchers has $2.3 billion in debt on its balance sheet, but it does not make the payments regularly. It is split up into a $300 million payment next April and a $2.0 billion payment in 2020.
I have no idea how Weight Watchers is going to make that payment in 2020. In good years, it only makes $100 million in profit (and keep in mind Weight Watchers is about to have a reorganization overhaul because the company is only expected to make $30 million in profit over the next 12 months.) But, at best, Weight Watchers will only be able to make $500-$750 million in cumulative profit between 2016 and 2020.
It suspended dividend payments in 2013. Some kind of reckoning could come in 2020. In a worst case scenario, Weight Watchers would go bankrupt. The unpleasant scenarios include secondary share offerings to raise cash that would dilute shareholders heavily and wreck total returns (think Citigroup and Bank of America in 2008). Another possibility is that Weight Watchers management could somehow borrow yet again to come up with cash to make the $2.0 billion payment. The problem is that interest rates for borrowing are likely to increase in the coming years, and this response would also be punitive.
This is an example of what happens when a company gets carried away with borrowing to repurchase stock. Weight Watchers management was issuing debt to repurchase 15 million shares of stock at $87 per share. That was not wise because the company does not possess the cash flow to make the debt payments. Now, people have realized that something is wrong when a company has a best-case scenario profit rate of $100 million annually and is sitting on a $2.0 billion debt payment, and the price of the stock has plummeted to $6 per share.
That is why old-time conservative investors grow wary when freshly-minted MBAs show up with financial engineering plans to grow earnings per share. It is dangerous trying to achieve better results than the growth of a business naturally merits. Weight Watchers is a perfectly good business that generates a profit every year. If your family owned the business free and clear, you would get to have an amazing life and see $12,000,000 show up in your accounts every month.
But this otherwise sound company has become overwhelmed with debt. A P/E analysis or an independent thesis about growth in the diet sector wouldn’t reveal the trouble that lies ahead for Weight Watchers. That $2.0 billion debt payment in 2020 is completely out of proportion with the $100 million annual profits in good years, and $30 million in profit expected over the next twelve months. It is a reminder that you have to study the company’s balance sheet before making an investing decision, and a testament to what happens when management teams pursue debt-funded buybacks in the short term without giving a hoot of the long-term burden to shareholders once the management team collects a financial package and decides to peace out. I write about Berkshire Hathaway so much because it is just about the only large company that takes a strong stand against this kind of thinking. Weight Watchers just happens to be the latest, and most egregious, example.
Originally posted 2015-05-22 12:07:10.