In an earlier life, I lived in Europe for a short time. One of my quickest and least beneficial realizations was that gyms in Europe sorely lacked in equipment, availability, and price. The availability was scarce (there were not many gyms – let alone decent ones), the equipment was old or ridiculous (see shake weight), OR the fees were asinine. The UK and Ireland were the best, but far from where the USA was at the time. In the UK, there were some decent health clubs, but overwhelmingly they were massive and expensive. They had pools, squash courts, basketball courts, tennis courts, tracks, and saunas. They offered great amenities to those that had 30 hours per week to hang out at their gym with ambitions to become proficient at every athletic endeavor one could think of. Worst of all was the cost – ranging from £60-100+ per month. This was 5-7 years ago. Things are changing.
A number of low-cost operators have started to pop up in the past five years and have gained all the momentum in the space. One of those low-cost operators is The Gym. It’s a somewhat new operator that’s trying (and so far, succeeding) to change the good ole’ health club model. The Gym went public in November 2015 at £1.95 and since then, the stock has traded almost completely sideways while the underlying business has gotten better. Some of this sideways trading could be due to the exit of the private equity sponsors in September of 2016 and March of 2017. With the PE money now out, the selling and secondary pressure could be dissipating. But in reality, I have no idea why stocks do what they do over a short (2yr) period of time.
The runway: The Gym sees themselves getting to 250 gyms in the UK before thinking about expanding elsewhere. They currently have about 90 gyms in operation, meaning they plan to grow 150% in the UK alone by opening 15-20 locations per year. In the UK, there are about 9.7 million gym members and that number is growing at about 6% per year. There are 6,700 gyms in the UK with only about 8% of the market in the low-cost camp (of which The Gym is solidly in the bottom quartile). That low-cost camp has grown members at a 40%+ compounded growth rate for the past five years. Low-cost gyms like FitX, Pure Gym, and Xercise4Less (maybe the cheap went too far on this last name) are leading the growth rates at 25%+ member growth per year. Mid-tier and premium gyms are losing market share quickly (-18% over the past 6 years) while low-cost and public gyms are gaining market share while gym customers move down-market. (The low-cost theory, one to which I subscribe, is who really wants to pay £100/month for all the amenities when you only use 1/10th of amenities. I just want to get fit and healthy and I’d like to do it for the monthly cost of a dinner at Olive Garden and without going to a massive box complex far from my house). Beyond the existing gym users moving down market, these groups are capturing basically all that 6% industry growth. Apparently, there seems to be a number of gym-goers who feel the same way I do.
The customers: First, the price is very nice. Each customer’s bill is a no-contract, with no cancellation fees at an average of £14.30 per month. 30% of their customers have never used a gym before – bringing an entirely new cohort into the revenue mix. 2016’s Net Promoter Score was a solid 62.2. Members have grown from 7,000 in 2008 (the year the business was started) to just over 500,000 today – up from 225,000 in 2013 and 376,000 in 2015. In 2016 The Gym had 21 million visitors in their gyms.
The business: They currently are and would like to be the low-cost provider for gyms in the UK. They aim to do this by using technology for all sign-ups, admissions, check-ins, and billing as well a skeleton crew running the gyms. They employee one manager and assistant manager per location and all their personal trainers (12-14 per site) are self-employed and each puts in about 10 hours per week. The Gym doesn’t charge the trainers for use of the gym and anticipates these trainers will bring in new members at no incremental cost to the gym. Employee costs as a percentage of revenue run at about 6% (vs. my checks showing 20-30% for a typical gym). The company opens a gym with about 3000 average opening members (pre-bookings through first two weeks of business) and aims to grow the per-location membership to 6000+ members over 3 years. For every location they open, they turn down about 30 sites. They seem to be quite picky on their locations as evidenced by no site closures since they started the business. They refurbish to match new fitness trends and ambiance every five years.
The Economics: The Gym has two role models and acts as a blend of the two: Easyjet and Planet Fitness – both low-cost providers doling out to their shareholder’s wonderful long-term returns. The management is focused on return on capital and employee ownership. The annual site economics of a mature gym looks something like this (all numbers in GBP):
|New Gym Cost||1,450,000|
|Mature Gym Revenue (6000 members * £14.3 * 12 months)||1,028,880|
|-Fixed Property Costs||-267,508.8|
In English, buildouts for the past couple year have gone something like this: a new gym costs about £1.4 million. The location is running at breakeven by about month three. By year three (at maturity with ~6000 members), the gym produces about £400k in earnings before interest and taxes. The company has negligible debt and therefore pays very little interest. In other words, the return on capital employed is close to 30%. The after-tax return is still incredibly attractive at over 20%.
The business can reach breakeven within a few months of opening, is profitable year one, probably gets 20%+ returns on capital in year two and by year three churns out a 30% return on capital.
Well, what does something like that cost?
Imagine for a minute we look three years out from today (I know, forecasting!) and assume the company completely stops at 95 gyms (roughly today’s level), lets them mature, and reinvests only enough to keep them competitive then and milks this business like an annuity. We’ll give them no credit for plans of future growth to 250 gyms.
At the end of 2019, there would be 95 mature gyms, each producing about £390k of EBIT. That’s £37 million in EBIT coming from the gyms. Subtract the corporate costs conservatively running at about £11 million per year and we’re at £26 million in profit before tax on a market cap of £230 million today. Net debt is about £5 million, so if I was buying this business I’d be on the hook for about £235 million. So under this scenario, I’d be paying about 9 times the annual pre-tax earnings. Further, if we assign them a tax rate of 19% (in line with historical) then I’d net about £21 million per year on my £235 million investment. That means I’d be paying about 11.2x earnings or locking in a yield of roughly 9% (1/11.2). Today, the going-in yield of the S&P is about 4.2% (1/23.6) so we may be on to something.
The company is not stopping at 95 gyms. If this company continues to have the ability to reinvest free cash flows at anywhere near that 30% with any newly minted capital, they better do it. Chipotle, Easyjet, and Planet Fitness have all shown us how attractive that can be. The CEO, John Treharne, also knows how attractive that is. Part of my interest here may have come from some type of pattern recognition watching Chipotle. I have no opinion on the stock and haven’t for years, but in their earlier days they were putting up new locations for extremely cheap, reaching profitability very quickly, earning extremely high returns on capital, and redeploying those profits into additional locations. The Gym kind of, sort of, looks like that.
Another way to look at it whether the price makes sense is the ever-wrong but directionally helpful discounted cash flow. I think there’s probably £19 million of earnings power or free cash flow produced to an outright owner in 2017 (if you want to know how I got there, email me – but it’s basically a 2:1 mature to immature gym ratio). There are 128.5 million shares outstanding. Let’s assume the business can grow its cash flows by 8% for 5 years, then 6% for another 5 years (both are probably conservative considering the company plans to open 15-20 gyms per year – so from a base of 95 gyms we might expect the gym count compounded growth rate to be about 13.5% over the next five years). We then sell the business at the end of 10 years for 10x cash flow. At a discount rate of 10%, that’s a present value of £298.5 million vs today’s market cap of £230 million. Not a total bargain, but probably safe, and maybe a ~15% CAGR for the next 5 years on conservative assumptions.
The management: John Treharne has done this before. He built Dragons Health Club from 1988 and sold it for about £31M pounds in 2000. He seems to act like an owner with a strong focus on return on capital, NOT on the number of clubs or members. That kind of logic melts my heart. In his own words “I’m happy to be number two”. He’s bent on being the low-cost provider and a technology leader in the space. If interested, I’d suggest reading a bit more about him as well as the annual report.
Of course, this business is not too moaty. It’s not that sticky of a business and customer switching costs are low. It’d also be relatively easy for new entrants to start up gyms and try to compete. I think it’s unlikely that a substitute pops up that makes fitness no longer desired or necessary. Crossfit (although I like it) is probably not a disruptor in this space or price point. Bargaining power of suppliers and customers isn’t too much of a threat here in my mind. Like a lot of decent to good (but not great) businesses, the reason they succeed is not because of a crocodile and piranha infested moat, but rather it’s because they have good managers who care about their culture, and have return hurdles who think about return on capital. It has some small scale advantages, know-how, and local dominance. Most of all, it’s a disruptor that’s changing a stale industry that probably has a runway to disrupt for a while until it eventually gets disrupted itself.
The company does some stupid things too.
- Why pay a dividend when you can reinvest at a 30% return on capital employed? I’d like a rational answer, not one that invokes the institutional imperative.
- Less offensive but still stupid is executive pay packages linked to earnings per share, EBITDA, etc. I’d much rather see long-term incentives (like the pay package at CMPR).
As is forever and always the disclaimer, this is not investment advice. Do your own work and verify your own numbers. I might buy, sell, or ignore anything at any time.
Some good sources for further digging: