One way to uncover great companies is simply doing a screen of 10-year ROICs. Most of these companies are never available at decent valuations but Weight Watchers has had a particularly terrible year and is now trading at just under 14x trailing earnings.

My interest in Weight Watchers was piqued by its returns; in the past ten years, it returned an average of 20.7% on assets. Over the past five years, invested capital has actually dropped by $150m but free cash flow has increased by over $100m. Clearly, this speaks to the quality of the underlying business.

Weight Watchers makes the majority of its revenues from the fees charged to attend its meetings. Scepticism about this aspect of its business focuses on two points. First, there is a perception that online services (some of which are free) are just as effective. I do not know whether this is true or not but research does show that some of these services are effective; this does not nullify the fact that there is also a vast amount of research showing that Weight Watchers works too. Further, the company is growing its online business.

The second point is related; Weight Watchers is seen to be exploiting its customers. Investors are often too quick to dismiss this sort of claim. Weight Watchers really has nothing apart from a brand; perception (not truth) is key. At some level this claim seems accurate as it isn’t totally clear what the company brings to the table; isn’t Weight Watchers really just making money from bringing people together? However, the fact is that no-one else is doing this, no-one has the same record of success, and it is really hard for anyone (apart from perhaps a government) to break in and build the reputation/brand that Weight Watchers now has.

Weight Watchers was bought from Heinz by Artal (a private equity-ish company) in 1999. Since then, the company has expanded into new areas effectively leveraging the Weight Watchers brand and meetings. For example, in 1997 product sales at meetings were $30m, in the LFY they were over $330m. Another example is online revenue; this division was consolidated in 2004 with $65m in revenue, in the LFY it achieved just under $400m.  The former seems to have grown to its limit and follow trends in meeting fees; the latter has compounded sales growth of over 20% for the last five years and is clearly going to be the engine of any future growth.

The hope appears to be that online will lead future growth however, by my calculations, the price that Weight Watchers can charge (per paid week) is just under half of that for meeting fees. The non-online part of the business is still valuable, although online will soon be the same size in terms of paid weeks. Moreover, the core business did surprisingly well during the recession. Attendance dropped significantly but paid weeks and, therefore, meeting fees increased. The current fiscal year was poor but this was partly due to a huge 2011 and significantly increased marketing expenses. In the future, there is the possibility of new markets and, of course, the general growth of obesity and its solutions. Both of these factors suggest that growth can still be achieved, although at a slower rate, in the non-online part of the business.

Shareholders have one other factor to consider: the 51% shareholding of Artal Group. As mentioned above, they bought the company from Heinz in 1999 although the people behind the transaction, the advisers to Artal, were Invus Group. The deal worked out well; Weight Watchers was bought for $735m of which $224m was equity. According to Forbes, Artal has taken out $3.8bn and still has 28.7m shares worth some $1.7bn. Artal appears to be committed to Weight Watchers in the long-term and so, given their success up until now, someone that it may make sense to partner with.

However, through this year the company has been recapitalized. $1.5bn of shares were bought back by the company (Artal matched the $750m worth from the public to keep their holding constant) with new debt. I don’t think we can question the motives of Artal. They cashed out $750m but there is clearly only a certain level of capex a business like Weight Watchers can take. Growing marketing expenditures suggest that the company is responding to a tougher environment and not being starved of investment. However, debt is now just over 4x TTM EBITDA. Interest expenses are up (although the lower share count means EPS is up more) and the company, by my calculations, may not be able to pay anything out in the near future (they have 4x EBITDA limit for any capital returns, they may have gotten over this in the last quarter). It is easy to see why this is good for Artal, they take more money out and just keep going but for new shareholders it is perhaps more questionable. The company has swaps and the current cost of debt is under 3% but interest rates clearly aren’t going to stay here forever.

However, they may just stay low long enough. The leverage is not totally crazy and Weight Watchers is a very strong business, although one that does rely overwhelmingly on reputation. Moreover, I don’t think this is a sign that Artal is going to make it difficult for other shareholders. They have made a lot of money and clearly had a lot of success but increased marketing expenses suggest they want to keep going. Therefore, I think this is a good opportunity to partner with a motivated shareholder, to get a slice of the growing online business, to capitalize on growing obesity, and on the pessimism that seems to be surrounding the non-online business given the performance this year. The current price is certainly not amazing, above $60 this becomes far less worthwhile however, I believe this is a good opportunity to buy a share of an interesting business.

ROUNDY’S (NYSE:RDNY) – $211m

Owns and operates 158 supermarkets largely in Wisconsin. IPO’ed in Feb 2012 at $8.50 (22m shares, 14.7m new shares to pay down debt. 38% owned by Willis Stein (13.8m).

Valuation –

Currently trades at $4.62, earned $0.96 in the TTM -> 4.8x, projected earnings are $1.06, Forward P/E 4.32x, CFO-Capex in the TTM was $3.18 despite capex doubling. Overall very cheap for what appears to be a stable, well-established business although not one without problems.

Balance Sheet –

$690m of debt (EBITDA turn 3.45x), operating leverage with rental expense of $105.7m in FY’11 (off-BS liabilities). Inventory control is worsening, since FY’10 to the TTM 10 inventory days have been added (if FIFO, this would have been significantly higher).

Ex-PE Co. –

Perhaps the biggest problem with Roundy’s is that is ex-PE (bought in 2002 by Willis Stein). Roundy’s was previously a co-operative, owned 66% by wholesale customers, the remainder held by employees. The motive for the buyout was to sell the wholesale operations (which generated 50% of sales), leverage cash flows, and grow the number of stores (pre-buyout there were ~61 company-owned/operated stores, now there are ~160).

New management was brought in to manage this company led by CEO Mariano (previously ran Dominick’s which was sold to Safeway in 1998 and appears to have operated in Wisconsin market), much of the senior management appears to have followed, and only one is from old Roundy’s. 5 directors, including Mariano, 3 are Managing Partners at Willis Stein, the last is an ex-senior supply chain exec from P&G. As a “controlled company” (where Willis Stein have majority voting power) do not have to have independent directors (although it does need more independents for audit committee). Comp is generous but not ridiculous.

Presumed reason for IPO is the failure to find anyone else to sell it (Mariano appointment is relevant here) to or find anyone willing to refinance debt (although they kept filing with SEC until 2005 so maybe not). The price is down 48% since IPO. Willis Stein seems to have recovered a significant amount of their original cash investment of $314m (the net consideration was $543m, I estimate they have at least $175-200m back) so are probably quite interested to get out after having to dilute their stake (pre-IPO they owned around 20m shares, now they own 13.8m of 44m) and a poor IPO.

Main concern is that PE has bled the company dry and problems will start emerging. Management does appear capable though. Perhaps hoped Mariano could help with sale to Safeway as with Domnicks.

Weaknesses –

EBITDA margins down 128bps due to increasingly promotional marketplace. Debt/leverage is clearly a problem, not so much financial as the huge operating leverage involved with some $800m worth of leases. Minority shareholder, board is not independent, Willis Stein are quite small and local (based in Illinois) but one wonders how interested they are now they have most of the cash back (although current stake is still worth $63.75m). Wonder what other stuff may come out of the woodwork as time goes on. Unable to allocate a full position due to these weaknesses.

Strengths –

Long history in Wisconsin market means it has big stores in good locations. Majority of sales in number one market share markets. Believe they can leverage regional expertise to enter Chicago market. Very cheap. Decent management, who appear to be incentivized, Mariano owns 2.5% of the company. The Board appears to have cleaned up its act somewhat, no more loans/consulting agreements. Operating gains were realized in buyout: sales per store increased from $22.5m in 2002 to $23.7m in FY’11, profit per store increased from $710k to $902k (have margins been squeezed too far though?). Ultimately, is very cheap price for a decent, but not great, business.

Clarkson PLC is a company that has been covered here quite a few times. Since October the stock has come off about 12% and I thought it might be quite interesting to bring back the analysis with a quick recap on the company.

The first, and most important, point is that the shipbroking business is pretty decent. There are some issues, to be discussed later, that should lead us to question their reporting but the figures are, generally, pretty good. In the LFY, margins were over 20% and for a business which requires very little assets this clearly results in huge returns on investment. The drop off in margins for the first half of this year (first half margins appear to be lower, generally) has been unquestionably severe however, at 17% it is still a very good business. Moreover, the recent turmoil is, I would argue, benefiting Clarkson. Market share is being captured as the market has shrunk, when the volumes and prices recover Clarkson will clearly do very well. My view is, obviously, that given the troubles I am about mention this business is trading at a very decent valuation for the long-term investor.

Briefly turning to the short-term, the market is quite clearly very bad. It is still the case that supply is coming onto the market and financing conditions are extremely poor. Clarkson is more affected by this given that it runs a capital markets business. I am not sure how new this, there are clearly huge overlaps with brokerage, but I like this a lot and I think it will be an added bonus when the market recovers (it would also be good to see Clarkson break this out more so we can see the effect on margins). It will be perhaps unsurprising to most readers that I am not really too bothered by the recent turmoil. Shipping is very cyclical and this stuff happens (Martin Stopford’s book is a great place to get informed about cycles). Investors in Clarkson are being paid for the impatience of others.

However, there are some pretty serious issues besides this. First, Clarkson’s figures probably overstate both the strength of its balance sheet and the profitability of shipbroking, the reason for this is bonus accrual. One reason to get interested in Clarkson is the huge cash balance (there is no debt), at year-end 2011 this was some £130m, 57% of the current market cap. However, the bonus accrual account was actually some £60m of this cash balance. Moreover, investors looking at the recent interims would see some £40m flow out in the first half to pay for bonuses. Much of this cyclical, in 2011 the first half outflow was similar but the full year was only a £7m outflow but this kind of issue makes me nervous. It clearly demonstrates the very valid criticism that staff are very much in control in these kind of businesses, indeed staff actually are the largest shareholders owning over 25% of the company. Everyone on the same side is great but it makes it very difficult to see how Clarkson has managed costs, the figures we have suggest they have done well but who knows? More to the point, it makes it difficult for investors to say that this cash should be returned to investors. Presumably, if the account was £60m and the liability is current then £60m in cash was needed through the year. The company has a decent credit facility of £25m and has put £20m in short-term deposit but can they do more? Even without the cash, and with the bonus accrual, the valuation is still quite favourable.

What has been a more worrying issue is the growing losses in financials. I am not going to go into detail but it seems like this was something of a vanity project that went horribly wrong. The company is trying to retrench to shipbroking but is now maybe stuck with a commitment to make markets for customers. Either way, this is clearly a terrible business with widening losses maybe coming in at £10m this year. Considering broking made £35.9m in 2011 (other parts kicked in about £4m too) this loss will clearly be a substantial hit.

Investments in “support” are questionable too although less of a problem as it contributes cash, 2011 ROA was 12.2%. However, shipbroking makes nearly double this. Support is probably worth £25-30m and it really isn’t why the company has bothered to invest here when it has such a great business to start with. I am sure there may be some reason I am not aware of but I suspect a desire to dampen the cyclicality of shipbroking was one, I don’t think this is a good enough reason to waste money.

Regardless, I think this should make investors question management, Financial is being wound down but clearly not fast enough. I like the company but I am not surprised it sold off aggressively given the lack of response to a severe worsening in the business. CEO Case is from shipbroking so hopefully he is the right man to retrench in that direction but performance this year is not encouraging. More generally, I would like to have more detail about the bonus accrual and the capital markets division. I don’t think it is time to panic by any means, it is time to ask questions though.